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News & Articles
FEATURE ARTICLE
| 08/18/10 | Investing in a Rising Tax Environment |
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Summary: In this paper, we discuss coming tax increases, and how investors and business owners might respond to them proactively.
You don’t need a crystal ball to know that taxes in the United States are going up. Soaring deficits created during the Bush years and further expanded by Obama’s stimulus spending during the “Great Recession” have raised the United States’ debt to astronomical figures. This is forcing many respected economists to worry that US Treasuries and the dollar might soon lose it’s favored status among world reserve banks, driving interest rates, and therefore the cost of US borrowing, much higher. At the same time, the federal government is investing in major new programs over the next few years, not least of which is the new healthcare legislation. With two wars underway, 10% unemployment, anemic 1-2% economic growth, and rising state and federal deficits, and now, new social programs to fund, the United States needs revenue -- and it needs it now.
So, what does that portend for high income earners? Higher taxes.
Hike from Health Care Legislation
Starting in 2013, if your income is above the $200,000 to $250,000 level, you will pay an additional 1% percent on your federal payroll taxes, and your investment income and gains will be bumped up by 3.8%.
Higher Income Taxes for High Earners
For income taxes to go up next year, all Congress has to do is sit on their hands, since the 2001 and 2003 tax cuts are due to expire this year. Unless the Bush tax cuts are extended, the top income brackets of 33% and 35% will revert to 36% and 39.6% respectively. The 36% increment will include singles with taxable incomes of $192,000 and married couples filing jointly with incomes above $232,950. The 39.6% bracket includes everyone (singles or married) earning above $375,000. The 10% tax bracket would also go away if the law reverts, making 15% the new lowest tax rate.
Investment Gains
This is another “do nothing” tax hike. Long term capital gains and qualifying dividends, which have been at a 15% maximum rate for several years, will automatically go up without Congressional action; the capital gains to 20% and the dividends to be treated as ordinary income. Let me say that again -- dividends will now be treated as ordinary income, subject the same tax rates previously discussed. We do hold some hope that congress might act to fix this by locking the dividends in at the 20% rate, which is certainly better for higher income earners, albeit still a 33% increase on investment income! Also, recall from the earlier discussion of the healthcare tax increases, if you are in the the $200,00 to $250,000 income levels, you will be adding another 3.8% to those gains taxes starting in 2013.
Estate Taxes: They’re Back!
There is no federal estate tax this year (2010), but, without Congressional action, it will automatically revert to 2000 levels starting in 2011. What will this mean? Estates between $1 million and $10 million would be hit with a top rate of 55 percent while those above $10 million would pay 60%. However, many congressional leaders had promised to reinstate the 2009 rules – no tax on estates up to $3.5 million ($7 million for married couples) and a maximum rate of 45 percent on assets above that level. That said, with all the other tax increases on the table for political debate, many experts think it is unlikely congress will act, and expect the $1 million dollar exemption to return.
Less Deductions for High Earners
President Obama’s 2011 budget calls for reinstating the phase-out of personal exemptions and itemized deductions for taxpayers in the two highest brackets. One proposal would cap the deduction rate for these brackets (36 percent and 39.6 percent) at 28 percent, which will certainly raise the ire of organizations who depend on charitable contributions. Those of us who are charitably inclined will hopefully not stop giving in 2011, but the benefits of doing so on our taxes will likely be diminished.
Strategies for mitigating the impact of higher taxes
You should always consult your investment advisor, accountant, or estate attorney before taking action, but here are some strategies to consider in proactively managing taxes. Realize Investment Gains and Harvest Losses
Given the 33% increase in long term capital gains taxes coming in 2011 , now is a good time for investors to review their holdings and consider trimming any investments that need to be sold in their accounts, particularly if they have sizable gains. Selling in 2010 secures the lower tax rate. Investors should also always look to harvest and book losses in their taxable portfolios, so they use them to offset gains in future years.
Review Investments for Tax-efficiency
While portfolios should always be allocated to maximize after-tax performance, now is a also a good time to consider the overall tax-efficiency of the investments in your accounts. Certain investments pass through considerable short-term gains and ordinary income through to investors each year, including mutual funds, Real Estate Investment Trusts (REITs) and Commodities funds. Asset location can be very important. REITs, for example, are best suited in tax-deferred accounts, and Municipal bonds, which can offer tax-free income at the federal and state level make sense for taxable accounts. In addition, one of the major disadvantages of mutual funds is that they pass capital gains and dividends through to investors each year, even if the investor hasn’t traded the fund, which can greatly reduce the after-tax return of these assets. To address this issue, for taxable accounts, investors should consider more passive investment vehicles to reduce the impact of taxes. Exchange Traded Funds (ETFs), as example, are not required to pass through short-term gains, and they generally have lower expense ratios and lower internal turnover than most mutual funds.
Defer Compensation
For small business owners or executives employed by firms that offer deferred compensation programs (sometimes called “Top Hat” plans), 2011 might be the year to start increasing the amount of income you push out into the future. By delaying income, you can reduce current income taxes, and re-invest deferred compensation in the same types of investments you use for your 401(k), all with tax-deferred compounding.
Converting IRAs to Roths now instead of later
For individuals planning to convert a traditional IRA into a ROTH, 2010 tax rates are lower, and it might make sense to talk to your fiancial and tax advisors to determine if this makes sense to do now versus later.
Pull in Charitable Gifting
If caps on charitable deductions might reduce your ability to give in 2011, you might consider giving more this year, taking full advantage of the tax deduction, and then offset your giving next year.
Talk to your Estate Attorney
Estate tax laws are currently in considerable flux, and it’s difficult to predict what actions Congress might take, especially during an election year. Talk to your financial advisor and your estate attorney about ways to mitigate estate transfer taxes and construct your estate in the most flexible way possible to take advantage of future changes to the law.
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