Affluent brace for Obama's tax hikes

Few loopholes, but some rate-reducers do exist; muni bonds, Roth IRAs top the list

Apr 5, 2010 @ 1:07 pm

By Bloomberg News

Economist Arthur Laffer, 69, took a radical approach to rising income taxes four years ago: he moved to Tennessee from California.

Laffer, who was an adviser to former President Ronald Reagan, said he'll stay in Nashville, Tennessee, which doesn't tax earned income, offsetting U.S. tax rates that are set to increase over the next three years.

In 2011, income tax rates for the highest earners will go to 39.6 percent, up from 35 percent, and the capital gains tax will rise to 20 percent from 15 percent, unless Congress acts. The increases aren't likely to be overturned by Congress, said Chuck Marr, director of federal tax policy at the Washington- based Center on Budget and Policy Priorities.

The capital gains tax will rise to 23.8 percent in 2013, to help pay for health-care reform signed by President Barack Obama March 23. That's because the legislation applies a 3.8 percent Medicare tax on unearned income such as realized capital gains, dividends, interest, rents and royalties. The health-care bill also increases the employee's share of the Medicare payroll tax levied on wages by 0.9 percentage points to 2.35 percent in 2013.

Both increases related to the health-care legislation will apply to about 1 million individuals who earn more than $200,000 annually and about 4 million couples who file jointly and make more than $250,000.

“No loopholes stick out,” said John Olivieri, a partner in the private clients group at the law firm White & Case in New York. “But you can take advantage of opportunities to reduce or eliminate the tax on investment returns.”

Laffer said some taxpayers paying top rates may respond to mounting federal and state levies by moving, like he did. Others may try tax-reducing strategies such as deferring compensation, investing in municipal bonds or converting to Roth Individual Retirement Accounts, said Nick Stovall, chief tax strategist at Gradient Investments in Shoreview, Minnesota.

Investors may also defer paying capital gains taxes by holding onto stocks for longer than they'd planned or only selling when they can offset gains with losses, said Mitch Drossman, national wealth strategist for New York-based U.S. Trust, which manages $188 billion in assets.

A couple who earns $450,000 and has investment income of $100,000 would owe $5,600 more because of the legislation: 3.8 percent -- or $3,800 -- on the $100,000 in investment income and an extra 0.9 percent -- or $1,800 -- on the $200,000 in wages that exceed the $250,000 threshold, according to an example provided by U.S. Trust.

Higher taxes may reduce the capital available for private spending, lending or investment, which will prevent economic growth and expansion of business, said Bill Baldwin, president of Boston-based Pillar Financial Advisors, a fee-only advisory firm.

More executives will opt to defer some of their expected 2011 bonus compensation as early as this year through non- qualified deferred compensation plans, said William MacDonald, president and chief executive officer of the Retirement Capital Group, an executive benefits consulting firm based in San Diego. The plans allow highly paid employees to defer a portion of their salaries or bonuses until a future date, such as retirement, and are not subject to contribution limits set by the government for retirement accounts such as 401(k)s.

About 85 percent of Fortune 1000 firms surveyed offered such accounts last year, according to Clark Consulting, a Dallas-based firm that designs compensation plans. Taxpayers who use these accounts can time when they want to receive their money and pick where they're going to live when they receive it, such as a low-tax state, MacDonald said.

Tax increases don't end with the federal government. Nine states including New York, Connecticut and New Jersey raised personal income taxes last year to as high as 11 percent on top earners, according to the Washington-based Tax Foundation, a nonpartisan educational organization.

“Some states are targeting high-income earners to pay for their budget deficits,” said Mark Robyn, a staff economist for the Tax Foundation.

Municipal bonds are the most beneficial investment for taxpayers in the $250,000 and higher group, said John Miller, chief investment officer at Chicago-based Nuveen Asset Management. The bonds are generally exempt from federal taxes as well as state and local levies for residents in most states where they're issued.

Investors should avoid having more than 50 percent of their municipal bonds issued from one state and keep the duration to no more than six years, said Dan Yu, a director at New York- based Eisner LLP's personal wealth advisory practice group. They should also research the credit quality because of the stress on state budgets and potential for rising interest rates, said Yu, whose firm's typical client has $5 million to $10 million in investable assets.

Tax-exempt municipal bonds due in 8 years to 12 years were yielding an average of 3.61 percent in March, according to Barclays Capital indexes. That's the equivalent of 5.98 percent taxable-bond yield for wealthy investors, if the top income tax rate rises to 39.6 percent.

Roth IRAs will be “more attractive” than traditional accounts, according to Drossman of U.S. Trust, the private wealth management unit of Bank of America Corp. Although distributions from Roth IRAs and traditional IRAs are both free of the 3.8 percent Medicare tax, there are no required distributions from Roth IRAs.

When savers reach 70 and a half, withdrawals from their traditional accounts are mandatory. The payouts could then push retirees above the $250,000 family threshold and result in other investment income being taxed, Drossman said.

Higher capital gains taxes will mean people won't turn their assets over as much and hold onto stocks longer, said Tim Steffen, a financial and estate planning manager at Robert W. Baird & Co., based in Milwaukee. “That may hurt investors' portfolios if it keeps them from diversifying,” Steffen said.

Taxpayers may want to realize capital gains this year while tax rates are at 15 percent, said Ron Florance, director of asset allocation and strategy, who works in the Charlotte, North Carolina, office of Wells Fargo Private Bank.

Booking losses on some investments this year may also help offset future gains when levies are higher, said Matthew Keator, a partner at Keator Group LLC, a Lenox, Massachusetts-based wealth advisory firm. Investors may not have any losses next year if the market improves, which is why they should act now, he said.

Taxpayers can deduct up to $3,000 annually of capital losses that exceed capital gains to reduce ordinary income. They can also carry forward an unlimited amount of excess losses to offset gains in following years, according to the Internal Revenue Service.

The income thresholds for the Medicare taxes are not indexed for inflation, which means that more taxpayers will be subject to the levies over time, according to the Tax Foundation. An income of $188,000 in 2010, assuming a 2 percent rate of inflation annually, would equal $200,000 in 2013, according to the group.

“It's very difficult to avoid the tax,” said Keator. “There's not any silver bullet.”


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