Eight tax strategies for advisers to consider

Fiscal cliff worries spark ideas on dealing with possible increases

Sep 9, 2012 @ 12:01 am

By Liz Skinner

Clients are peppering financial advisers with questions about how to prepare for steep tax increases that could result from a national tumble off the fiscal cliff.

The trouble is that most advisers can't answer those questions — at least with any degree of certainty.

Many of the increases slated to take effect next year could be reversed or delayed — at least for some taxpayers — depending on who wins the White House and what Congress decides to do between now and the end of the year.

“It's too close to tell and it's too soon to tell,” said adviser Keith Newcomb of Full Life Financial LLC, who plans to wait until closer to the end of the year to adjust portfolios. “You don't want to jump the gun.”

Other advisers are making recommendations now.

“It's best to move ahead based on today's rates,” said Kurt Laubinger, president of Potomac Wealth Management LLC. “It's not likely that things will get more favorable from a tax standpoint.”

The most severe increase in rates will occur if the Bush-era tax cuts are allowed to expire at year-end. With no congressional action, the top ordinary income tax rates are set to rise to as high as 40%, from 35%, for the nation's top earners.

In addition, if the 15% tax rate for qualified dividends expires, they will be taxed as ordinary income. The 15% rate on capital gains is scheduled to rise to a high of 23.8%, including the 3.8% Medicare surcharge on investment income for high earners.

Here are eight strategies that advisers may want to consider:

1 Sell investments such as concentrated stock positions, businesses, real estate or other assets that would trigger capital gains and harvest some losses for future years, when capital gains rates will be higher.

Why: Long-term capital gains rates will rise to 20%, from 15%, if Congress doesn't act. In reality, the rates for affluent Americans will be 23.8% because of the 3.8% health care reform tax that starts next year.

Why not: Selling securities to lock in the tax rate won't make sense in every case. For example, cashing out an investment with a $1,000 gain and reinvesting the funds in a security that earns an average 8% a year will in 10 years net the investor $1,638. Keeping the investment and paying a 20% capital gains tax over 10 years will net $1,727.

2 Receive ordinary income from sources such as individual retirement accounts and annuities — or exercise nonqualified stock options — this year rather than later to avoid higher income tax rates.

Why: The top ordinary income tax rate will increase to as high as 40%, from 35%, if Congress does not extend or rewrite the tax cuts enacted under President George W. Bush.

Why not: Such a move could be jumping the gun, because Congress has through Dec. 31 to edit the rules for next year. In 2010, the extension of the Bush tax cuts for 2011 and this year wasn't signed until Dec. 17.

3 Move money into holdings that aren't affected by higher taxes on investment income, such as municipal bonds, Roth IRAs, variable annuities and life insurance, or choose mutual funds or exchange-traded funds that are managed to be tax-efficient.

Why: Funds held in a Roth IRA for at least five years can be withdrawn tax-free (if the person is 591/2 or older). Roths also have no minimum withdrawal requirements. Annuities offer a tax deferral feature. The death benefit on a life insurance policy isn't subject to income tax.

Why not: Income limits may make some clients in-eligible for Roth IRAs and some advisers shy away from annuities because of their price tags.

4 Back away from investment strategies that focus on income from dividends.

Why: If the qualified-dividend rate is allowed to expire, dividends will be taxed as ordinary income.

Why not: Some strategists think that the business pros-pects for the underlying companies are much more important to a stock's performance than the tax implications of the dividends they distribute. Moreover, many think that Congress will move to treat dividends in a similar manner as capital gains, with a rate not much higher than 20%.

5 Buy investments in which growth isn't taxed, such as Section 529 college savings plans and employer-provided retirement plans.

Why: Gains on funds invested in 401(k) accounts are tax-deferred, with the rate on withdrawals determined by the investor's tax bracket at the time. In the case of the 529 plan, as long as the money is used for higher education expenses it won't be taxed when used, either.

Why not: Federal law allows only two investment changes each year in 529 plans, which can be scary in volatile markets. There are limits on retirement contributions.

6Defer tax-deductible payments such as contributions to charities.

Why: Those deductions may be worth more if tax rates are higher in the future.

Why not: The deductibility of donations to charities could be limited or reduced through changes to tax laws by Congress.

7 High-net-worth families looking to transfer wealth should act to lock in potential savings before the end of the year.

Why: The marital exemption on the estate tax drops to $1 million in 2013, from $5 million, unless it is changed by Congress before year-end.

Why not: If Republicans gain control of the White House and Congress, they could do away with the estate tax entirely.

8To reduce the impact of the 3.8% health care surtax on investment income, invest in tax-exempt bonds and rental real estate, and use S corporations, Roth IRAs and installment sales.

Why: This is the one tax that is certain to hit wealthy taxpayers next year, so it is a good place to start with prevention techniques.

Why not: The rates of return expected on such investments or strategies might not be as lucrative as other investments.

lskinner@investmentnews.com Twitter: @skinnerliz

Upcoming Event

Oct 30

Webcast

Help Provide A Comfortable Retirement

When it comes to saving for retirement in volatile market conditions, clients face a tough question: Should I stay or should I go? Many investors shy away from investing when conditions are rocky.Performance usually lags behind the markets... Learn more

Accepted by the CFP Board for 1 CE credit and by IMCA for 1 CIMA®/CIMC®/CPWA® CE credit.

Get Daily News & Intel

Breaking news and in-depth coverage of essential topics delivered straight to your inbox.

X

Subscribe and SAVE over 72%

View our best offer
Subscribe to Print