It’s time to brace for higher taxes

The two major certainties in life have always been death and taxes, but modern medicine has managed to…

The two major certainties in life have always been death and taxes, but modern medicine has managed to delay death. It seems, however, that nothing can stop taxes.

Indeed, I am certain that higher taxes are in our future, and clients’ investment strategies need to take this inevitability into account.

Let’s start by outlining the facts.

Mathematically, the government’s spending is unsustainable at the country’s tax levels. Spending must be cut or taxes must rise.

History indicates that spending won’t be cut, so I have to think that taxes will, at some point, go up.

I also think that inflation will manifest itself and will mask — and actually worsen — the effects of the tax increase. Not only will each dollar be worth less, but the government will take more of each dollar as Americans are moved into higher tax brackets and more become subject to the alternative-minimum tax.

How can we help our clients minimize the damage from such a scenario?

There are several possibilities.

The first, a counterintuitive idea, is to take a look at paying taxes now, when rates are lower.

The second, and arguably more important, is to focus on low-turnover investments. In a high-tax envir- onment, any avenue that allows you to defer gains can potentially add value.

Dividends and active tax management. In a higher-tax environment, holding periods will lengthen as clients look to defer taxation as long as possible. Long-term stock picking will take the place of trading strategies. Long-term gains and dividends will be more effective than short-term gains and realized capital gains. As a result, buying and holding large-cap dividend payers with dividend reinvestment plans may prove to be a good solution. Dividends, which typically increase over time, should help provide inflation protection. The types of stocks that would likely be appropriate in this situation are the Standard & Poor’s Dividend Aristocrats.

Further, as active trading in search of capital gains becomes less attractive, active trading for tax reasons will become more attractive. For clients in higher tax brackets, separately managed accounts, which provide active tax management, might add value. Even for long-term holdings, the potential to harvest tax losses can add effective alpha to portfolios. Vehicles that don’t leverage tax management opportunities will become relatively less attractive for “wealthier” clients at the same time as these wealthier clients become less so, as the AMT catches more and more people.

Strategic asset allocation. While this is happening, asset allocation will have to become more strategic and less tactical. Despite its potential tax advantages, a longer-term holding strategy provides less opportunity for clients to adjust their portfolios in response to changing economic conditions. Because of this, I believe effective diversification will be essential. As we know, during the 2008 market crisis, diversification among the established asset classes was shown to have limitations. Consequently, asset classes that are now considered alternatives — such as managed futures, hedge funds and gold — will play increasingly important roles in portfolio allocations. For example, you might establish a “permanent” portfolio with a relatively stable mix of noncorrelated asset classes, each diversified by strategy.

Much of the above discussion relates to taxable portfolios, so you may be thinking, “What about tax-deferred portfolios?” To this question, I answer that as our nation’s fiscal problems worsen, the scope for tax deferral will narrow, and you may not want to rely on its continued availability.

Just as the need for revenue will drive rates up, it also will widen the net. Some have suggested that the government might require a certain percentage of tax-deferred portfolios to be invested in government bonds to preserve their tax-deferred status.

Ridiculous idea? I hope so.

Other potential risks to tax deferral include taxing returns above a certain “reasonable” level, which was done as recently as the 1990s, and anything else that might fill the revenue hole.

The specifics, of course, will change over time. What won’t change are the government’s need for revenue and our need as financial advisers to structure our clients’ portfolios to minimize the consequences of inflation and tax increases.

Now is the time to start thinking about how to deal with the inevitable — not death, but taxes. After all, while death is worse, at least you don’t have to die every year.

Brad McMillan (bmcmillan@ commonwealth.com) is chief investment officer at Commonwealth Financial Network.