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Facing the Tax Mountain

The financial landscape in America is treacherous. It’s like sprinting down a narrow trail in thick fog with a fiscal cliff on one side and a tax mountain on the other. Taxes are undoubtedly going up for many Americans, particularly affluent households. If you’re facing the tax mountain, can you − or should you − do anything about it?

Let’s start with the 2013 tax law changes already in place that affect investment returns:

  • Ordinary income tax brackets for 2012 of 10%, 15%, 25%, 28%, 33% and 35% will increase to 15%, 28%, 31%, 36%, and 39.6%. Also, an additional 0.9% Medicare tax will be owed on employee income over $250,000 joint and $200,000 single.
  • A new 3.8% Unearned Income Medicare Contribution tax on net investment income for people earning over $250,000 joint and $200,000 single.  This hits interest, dividends, annuities, royalties, rents, income from a passive trade or business, and realized capital gains other than passive. Tax-exempt interest from municipal bonds is excluded.
  • The current qualified dividend rates will be taxed as ordinary income. Dividends will also be subject to the 3.8% Medicare tax depending on income.
  • Capital gains tax will increase from 0% to 10% for investors in the 15% bracket (8% for gains held more than 5-years), from 15% to 20% for all others brackets (18% for gains held more than 5 years). Realized gains will also be subject to the 3.8% Medicare tax depending on income.
  • Itemized deductions will be phased out for higher income earners. Net investment income will be counted toward earnings for the phase-out, thereby raising taxes.

No one can say how many of the above changes will take effect, change, be delayed or eliminated by the time we pay our 2013 taxes. I believe it’s highly probable that tax rates on dividends and capital gains will increase for higher income earners and that the Medicare tax on unearned income will stay in place because the health care law is certain to be implemented with President Obama’s reelection.

What can you do to prepare for the tax mountain ahead? Here are three views:

  • Sell appreciated assets in 2012. This will avoid higher capital gains tax and the Medicare tax on unearned income starting next year.  However, if you have no reason to sell appreciated assets, other than to avoid paying potentially higher capital gain rates in the future, then you would effectively end up prepaying future capital gain taxes now instead of over future years. Thus eliminating any benefit of the time value of money by deferring tax liabilities.
  • Wait until there is clarity in the tax code. It’s a toss-up that 2012 tax rates will be extended into 2013 because the increases affect all tax payers. However, it’s less likely that the 3.8% Medicare tax on capital gains will be delayed because the money is needed to implement the new health care law and the tax only affects affluent investors.
  • Never sell. This avoids both capital gains and the Medicare tax. In addition, appreciated assets step up to a new basis upon death without taxation.

Here are a few suggestions to consider that may aid in tax management going forward.

  • Equity index funds and particularly equity exchange-traded funds (ETFs) have very low capital gains distributions. Consider using these investments in your taxable accounts.
  • Municipal bonds will become more attractive to more people as tax brackets rise. Interest from tax-exempt bonds will remain free of federal taxes and the Medicare tax on unearned income.
  • Keep trading to a minimum using a low-turnover portfolio management approach. Sell gains only occasionally to rebalance your portfolio asset allocation for risk control.
  • Use any realized capital losses from tax-loss harvesting to offset realized capital gains and offset up to $3,000 in ordinary income.
  • Make the best use of funding tax-deferred and tax-free savings accounts, such as a Roth IRA, 401(K) plan, or 529 plans for college savings, etc.

How you face the tax mountain should be specific to your own situation. I am not a tax adviser and do not offer specific tax advice. Please consult with your CPA or a qualified tax adviser before proceeding.

NOTE: The content of this blog is intended for informational purposes only. It is not intended to provide legal advice. Laws differ by jurisdiction, and the information on this blog may not apply to every reader. You should not take, or refrain from taking, any legal action based upon the information contained on this blog without first seeking professional counsel.