Currently millions of taxpayers are trying to get their tax returns prepared. But if you are wise, you’ll look at what’s coming in 2013 and take action now to address it.
If the U.S. tax code remains as it currently stands, we will face the largest tax increase in history. The majority of this would come from the expiration of the Bush Era tax cuts. Current tax brackets would go from 10, 15, 25, 28, 33 and 35 percent to 15, 28, 31, 36 and 39.6 percent. Capital gains rates would increase from 20 percent for those who are currently subject to the 15 percent rate and those eligible for the current 0 percent rate would be subject to the 10 percent rate.
The most egregious taxes would be for qualified dividends. Rates would revert back and be taxed at ordinary rates. Those currently paying 0 percent in the 10 and 15 percent tax brackets would pay 15 and 28 percent next year. Those currently paying 15 percent would pay 31, 36 or 39.6 percent. Dividend-paying stocks have been in vogue, but this could quickly come to a halt.
In addition, the phase-out of itemized deductions and exemptions would return, affecting higher income households, while the marriage penalty would return.
Outside of the expiration of the Bush Era tax code, there are a few other taxes coming into play for 2013. The payroll tax cut is set to expire at year end. Also the 3.8 percent healthcare reform act surtax on investment income will start. For those who will be in the 39.6 percent tax bracket next year, their qualified dividend income will go from 15 percent to a whopping 43.4 percent, which doesn’t take state income taxes into account.
There is periodic talk about extending or modifying these tax issues, but I’m not holding my breath. Election years tend to create standstill before the election. After the election, lame-duck politicians are hard to rely on -- especially if the power is split up between political parties within Congress and the presidency. Rather than relying on politics and other things that we can’t control, I am advocating a more proactive approach. These are the things you may want to consider:
Tax location. This strategy involves allocating your individual investments into accounts in a manner that optimizes the after-tax efficiency of your overall portfolio. I like to call this tax account diversification as Roth IRA/401(k)’s are designed to be tax free, Traditional IRA/401(k)’s are tax deferred and then investors can also have regularly taxable accounts. You would be more cognizant of placing more of your tax-efficient investments within taxable accounts. Low turnover stock funds and index funds and municipal bond funds (if they don’t have a great deal of private activity interest which is subject to the alternative minimum tax (AMT)) are very tax-efficient in a taxable account. Roth IRA’s/401(k)’s are a great place to place the high-growth portion of your portfolio. The greater the growth potential, the more potential dollars you should have for your needs over the long haul; all of this would be tax-free. Mutual funds that invest in higher risk stocks and commodities tend to be a good location for a Roth. Tax-deferred vehicles such as Traditional IRA’s/regular 401(k)’s tend to be a great place for your slower growing diversifiers within the portfolio. Leaning toward slower growers in the tax deferred accounts means that less of your dollars will be subject to ordinary tax rates when withdrawn. Taxable bond funds and other high turnover/non-tax efficient strategies tend to fit well within the tax-deferred account. If you have a mix of different accounts, you will find this strategy more powerful in the years to come.
Tax gain harvesting. Most of the time financial planners talk about tax loss harvesting. But given the higher future capital gain rates, one may want to consider taking capital gains now at the current lower rate rather than incurring a higher tax rate later in the future, especially if you were planning to incur a capital gain with an asset sale in the near future. If you find yourself in the tax bracket where you would be subject to the 0% capital gain rate, it may even make sense to incur a capital gain only to buy the holding back to create the higher cost basis for a later sale date. It may defy common logic, but sometimes the best financial strategies are counterintuitive in nature.
Roth conversions. If you have a large portion of your portfolio in a Traditional IRA and enough funds outside of retirement accounts available to pay the tax (and if your taxable income will get hit the hardest by the tax increase), you may want to consider converting some or all of your Traditional IRA to a Roth IRA. In the future, I will discuss Roth conversions in greater detail.
Higher funding of tax-advantaged accounts. Higher future taxes increase the attractiveness of funding tax-advantaged accounts, whether they are IRA’s, employer-provided retirement plans, health savings accounts, college funding vehicles or tax-deferred annuities. Just make sure that you have accessible funds available for an emergency fund and future spending needs that aren’t subject to a tax penalty for early withdrawal. But it may make sense to keep your taxable accounts as small as possible.
Don’t let the tax tail wag the dog. Make sure that the funding vehicle fits your goals and future needs. Oftentimes I see people mistake tax efficiency for tax avoidance and they end up investing in areas that are a poor fit for their needs. For example, life insurance may be sold as an investment vehicle where a need for the actual insurance need should take precedent over the investment characteristics.
With some careful planning, there is a lot to benefit from if you think about your future tax circumstances right now. Before taking action, I would highly recommend working closely with your financial planner and tax accountant (and coordinate it so they are communicating to each other as well) to see what actions make the most sense for you. With our current and projected federal budget deficits, it would suggest we will be more likely to face a higher tax environment in the future. Small tax efficient measures now could potentially make a big difference over the long term.
Jeff Bogue is an independent, fee-only financial planner with his firm, Bogue Asset Management LLC, serving individuals, families and small business owners nationwide since 1997 with offices in Wells and Portland, Maine. Jeff has been a Certified Financial Planning Practitioner since 1997 and has been quoted on personal financial matters in the Wall Street Journal, Consumer Reports, Consumer Reports Money Advisor, Kiplinger’s Personal Finance, Businessweek.com, Bankrate.com The Portland Press Herald, AARP Magazine, Registered Rep.com, Fidelity Stages Magazine, AOL Money & Finance, MSN/CNBC.com, Investment Advisor Magazine, Financial Planning Magazine and Financial Advisor Magazine. He is an active member of the National Association of Personal Financial Advisors, the Financial Planning Association and the Maine Estate Planning Council.