October 23, 2012
8 Ways to Beat the Big Tax Increase
The Investment View from Prescott, Arizona
Congress has passed some of the biggest tax increases in history which are scheduled to take effect January 1st of next year.
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. Or maybe not. Any administration will be faced with having to find money to cover runaway government spending.
It does not seem likely that things will get better from a tax standpoint, so what is an investor to do?
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 39.6%, 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 – as high as 39.6% for some taxpayers. That is a huge increase.
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.
To soften the impact of these hikes, here are some strategies that you may want to consider:
1. Sell investments such as concentrated stock positions, businesses, real estate or other assets that would trigger capital gains. Consider harvesting some losses to reduce taxes in future years when 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. That adds up to a 58% increase in cap gains rates for some of you.
Why not: Selling securities to lock in the current tax rate won’t make sense in every case.
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 in future years.
Why: The top ordinary income tax rate will increase to as high as 39.6%, 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 ineligible for Roth IRAs and annuities have hefty fees built in. Tax efficient funds only defer taxes and may expose gains to higher taxes in future years.
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: Dividend paying stocks tend to be less volatile than non-dividend paying stocks. 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%. (23.8% with the health care reform tax added in)
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.
6. Defer 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 lifetime exemption on the gift/estate tax drops to $1 million in 2013, from $5 million today, 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.
8. To reduce the impact of the 3.8% health care surtax on investment income, invest in tax-exempt bonds, rental real estate and Roth IRAs.
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.
This article was excerpted from InvestmentNews September 9, 2012. Hepburn Capital does not provide tax advice. Please consult your tax adviser.
A Slice of Life
The Yavapai County Shrine Club sponsors 200 underprivileged children each year during December for Clothe-a-Child. Counselors and school nurses select the kids, 100 each from both Humboldt and Prescott school districts, and each child is escorted through Wal-Mart for $100 shopping spree – clothes, shoes and coats only. No toys or candy.
These kids get sooo excited shopping for themselves with the help of an adult escort. It is a very rewarding experience for us adults who help.
This year we are still about $4,000 short of being able to provide for all 200 children, and rather than turn kids away at the last minute, we are appealing to friends and neighbors to help out. If you would like to help sponsor a child, please make a check out to Clothe-a-Child and send it to the office (2069 Willow Creek Road, Prescott, AZ 86301). I’ll deliver it for you.
Shriners have fun while helping kids, but sometimes it isn’t as easy as we make it look. Thanks for your help.
Scottsdale Office Date
Please call our Prescott office for an appointment if you would like to meet with Will in the Scottsdale office. (928) 778-4000
How’s the Market Doing?
Yesterday’s (Friday Oct 19th) sharp decline in the stock markets came on the 25th anniversary of 1987’s infamous Black Monday that saw the stock market drop 23% in one day.
Eerily, Friday’s market action looked and felt a lot like the Friday before Black Monday due to the lack of buying interest. It wasn’t that there were huge volumes of stocks being sold, but that buyers just held back. You see, all it takes for a free-fall market like Black Monday is an absense of buyers. On Black Monday, buyers were spooked and decided to hang back and watch before buying.
We are in a very high risk period for stocks right now. The tech laden Nasdaq stock Index** has already broken into a clear downtrend and as I write this on Monday morning, October 22nd, the broad based S&P 500** is in the process of changing from a sideways “trading range” into a clear downtrend, by breaking through price levels from which it had bounced back off of several times in the recent past. At the moment it is falling and not bouncing.
I expect the markets to become more volatile as the election nears. After the election investors will be facing big tax increases slated for January 1st. If the new Congress will act to change things (big IF) that may still take a while, and I expect investors to begin to sell in November to protect themselves from the tax increases – just in case.
Markets don’t like change and elections certainly have the potential to bring change. That may be what we are seeing. Or perhaps it is the selling I foresee ahead of the tax increases that has already begun and is creating the glass ceiling for stocks that we have seen since mid September.
If that wave of selling materializes it will create a strong headwind for the stock markets through the end of the year. Buy and hold investors may need to tighten their seatbelts.
Answer: All the other cardplayers were women.
What’s Going On In Your Portfolio?
Due to the high risk nature of the current stock market environment, I moved into a more defensive nature last week, by reducing holdings of stocks and stock funds. If I am being overly cautious we will know in a few days and I will quickly go back to being fully invested.
Gold had a significant price breakdown last week, so I also sold off our gold holding. It could stabilize, but in a general stock sell off, gold often becomes a casualty too. And with a tough slog looking likely for stocks, I kept gold on a short leash.
I made the first change in a while in Flexible Income* portfolios last week, closing out the high yield bond fund we held to lock in the nice gain we had with it. High Yield bonds don’t do well in recessionary times, and with business slowing down and the stock market not making any progress for 5 weeks I decided not to push our luck on this particular holding. It was the only Flexible Income* holding that had not produced any gain in the past month, and it dropped to a price that said “sell”, so its outta here! We made a nice profit on it, though.
Our Municipal Income* strategy continues to perform well, and although you never know for sure, with the tax issues facing investors in 2013, I expect them to continue to do well for a while.
Time for a Review?
After a rough start to the year, both our Income* and Growth* strategies have turned around nicely in the past few months.
I rely on this newsletter to let you know what I am thinking and seeing in the markets, but it does not allow you to ask questions or express concerns. For this reasons, periodic reviews of your account(s) are important.
If you would like a personal review, either in person or on the phone, please call the office to schedule an appointment. (928) 778-4000
Don’t Get Too Excited Yet!
There’s a lot of excitement about the signs of recovery in home sales since February, shown in the left window of chart below. But looking at the long-term trend in the right-hand chart, perhaps the level of optimism is a bit high.
Our Spotlight Strategy
Municipal Income with its exemption from Federal Income Tax is garnering more attention as we get closer to the January 1st tax increases. Our muni portfolios have been our strongest performers this year. With our Muni Income Strategy we strive to provide high total return consistent with capital preservation using bond market investments. [Municipal Income]
If you would like a current copy of our SEC Form ADV, Part 2, it is on our website at hepburncapital.com/form-adv.html
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
Shock Absorber Growth
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable; however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.