On December 31, 2012 temporary federal tax reductions that were originally made in 2001 and 2003 (and extended in 2010) are set to expire. At the same time a number of government spending cuts will automatically take effect. Together this combination of changes has been described as a “Fiscal Cliff”. If no new tax policies are created or no extensions are made, then some tax rates may change significantly. Although seeing taxes increase while the U.S economic recovery is still tepid does not sit well with taxpayers or lawmakers, it appears unlikely any efforts will be made during the remainder of the year to address the issue. With the outcome of the presidential election still uncertain, policy makers will avoid “tackling” permanent solutions until well into next year.
Although there is plenty of uncertainty around the ultimate (or temporary) solutions to both tax increases and spending cuts, it does not mean investors should remain passive. Below are the components of the fiscal cliff that will have the greatest impact on your investments and suggested actions to successfully manage through this uncertain time.
Long-Term Capital Gains Tax Rate Changes
The Issue: Currently the tax rate for investments that are sold after being held a minimum of twelve months is 15%. If the current tax rates are not extended this rate will move to 20%.
What To Do: If you are holding an investment that is imbedded with large long-term capital gains (a business, highly appreciated stocks, collectibles, etc.) that you plan to sell in the next 18 months, you should consider executing the sale in 2012. The 5% tax reduction could be substantial on highly appreciated assets. Your accountant can be a valuable consultant for this analysis.
What Not To Do: If you still have tax loss carry forwards from investments sold in previous years do not try to offset the loss by realizing capital gains this year. Unless you need the money, your tax loss carry forwards would be better used when capital gains rates are higher.
Do not sell stock just because the capital gains rate might be higher next year. From a cash flow perspective realizing the gains now instead of holding them indefinitely does not make sense. Once an appreciated asset is sold you will be responsible for paying the tax in April. If you do not sell, the tax will be deferred to a future date. You may avoid the tax altogether if you never sell your position or you donate it to charity.
Probability This Change Occurs Permanently: 75%
Qualified Dividend Tax Rate Changes
The Issue: Currently the tax rate for qualified dividends (includes most stock dividends with the exception of Real Estate Investment Trusts and Master Limited Partnerships) is 15%. Without an extension or change, these dividends will be taxed at the investor’s ordinary income tax rate. For individuals in the highest tax brackets this could be as high as 39% in 2013. This is a big issue because the overall change in rates could be very significant.
What To Do: Investors should follow this potential legislation very closely. Even if this rate changes, it is unlikely to go to the most extreme scenario listed above. However, if it appears the qualified dividend rate will climb significantly, there is a lot that can be done:
• Allocate your portfolio using all of your accounts including qualified accounts (401(k) and IRA accounts). Place the dividend paying investments in the qualified accounts and the non-dividend paying investments in the non-qualified account. Any dividends received in the qualified account will be sheltered from current taxes and deferred until distributions are made.
• If you can handle a little more risk you could shift your allocation slightly to more growth stocks and less value stocks. Growth stocks generally provide the majority of investment return through unrealized and realized capital gains.
• Search for companies that use excess cash to buy back the stock of the company. This can provide appreciation to shareholders without creating taxable income.
What Not To Do: Do not make major changes to your overall portfolio that will significantly increase your risk. Small-capitalized growth stocks do not provide the taxable dividend income of large-capitalized value companies, but they present substantially more risk. The potential tax change does not insure a catastrophe for stocks of dividend paying companies. Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) currently pay dividends that are taxable at the investor’s ordinary income rate. For the last 12 months the Dow Jones Composite REIT index is up 24.62% and the Cushing 30 MLP Index is up 16.57% (All returns are provided by Bloomberg, LP for September 21, 2012). Finally, don’t indiscriminately sell highly appreciated dividend paying stocks. The tax on the realized gain could be considerably higher than the higher tax rate on the dividends in total dollars spent.
Probability This Change Occurs Permanently: There is a high probability that some change will occur with the dividend tax rate (75%). However, the change will probably not be to ordinary rates but could climb as high as 25%.
Overall Income Tax Rate Changes
The Issue: Currently, there are six marginal income tax rates in the United States that range from 10% to 35%. If the tax cuts expire with no extension or changes, these six tax rates will be reduced to five and the rates will range from 15% to 39.6%. Most taxpayers would see an average hike of 3% over their 2012 rate.
What To Do: With such a broad-based tax increase, there is very little to do from an investing standpoint that does not alter overall risk. For bond investors, the option to invest in tax-free fixed income should not be ignored. Municipal bonds pay interest that is federally tax exempt and state tax exempt for in-state issues (i.e. a California municipal bond interest is not subject to state income tax for California residents but it is for residents of other states). Not only does tax-free interest become more valuable at higher tax rates, the current yields on municipal debt is very favorable relative to other types of bonds. If tax rates do increase, investors should carefully explore the municipal bond market with a financial advisor.
If you are considering converting your traditional IRA to a Roth IRA in the near future you may want to make that change in 2012 to protect against a potentially higher tax rate in 2013. At a minimum, there is almost a zero percent chance tax rates will decline in 2013. Likewise, if you have discretionary income that can be received at the end of 2012 or at the beginning of 2013, it might be a good idea to take the income in 2012. To be sure, you should consult a tax expert and understand the effects on your particular situation.
What Not To Do: Don’t panic. Investments have performed well over long periods of time through a variety of tax increases and decreases. Do not stop investing because the government may be taking a larger share of your profits. Stay diversified with your investments. Not all investments will react the same to higher interest rates.
Probability This Change Occurs Permanently: 80%. With a ballooning national debt it appears clear that tax rates will have to increase to balance the budget and reduce the debt. It may not completely revert to the schedule described above but it seems fait accompli that there will be higher tax rates at the upper end of the tax schedule.
Estate Tax Changes
The Issue: Currently an individual can avoid taxation on $5,120,000 ($10,240,000) of his or her estate when it is passed on to his or her beneficiaries at the time of death. This is also the maximum amount a person can gift during his or her lifetime and legally avoid having it taxed. The tax rate on assets passed beyond the exempt amount is 35%. If no changes are made the exempt amount will drop to $1,000,000 per individual ($2,000,000 per couple) in 2013 and the tax rate will increase to 55%.
What To Do: Evaluate your entire estate. If you and your spouse have an estate valued in excess of $2,000,000 you may want to consult with your accountant, financial advisor or estate planning attorney. If you are planning to gift in excess of $2,000,000 to your children within the next several years you should definitely address this issue prior to the end of 2012. If you have a very high net worth (over $50,000,000) and feel certain you will not spend it all during your lifetime, you should move quickly to pursue the tax advantages available in 2012.
What Not To Do: Don’t start with buying an excessive amount of life insurance, which can be expensive and unnecessary. Consider hiring a neutral professional (Certified Public Accountant or Certified Financial Planner) to review your specific situation and make an independent recommendation. If you are uncertain whether you will spend most of your estate during your lifetime, you do not want to transfer a significant portion of your estate at this time. Once assets are gifted they are out of your control and cannot be used later in life.
Probability This Change Occurs Permanently: 90%. The estate and gift tax exemption will likely see an alteration. A popular potential solution would be a reduction of the exemption amount and an increase of the tax rate from 2012 levels. A best guess is that a new exemption amount will be established between $1,000,000 and $5,000,000 per individual and the new tax rate will be set between 35 and 55%.
D’Arcy Capital Management LLC Approach
At D’Arcy Capital Management LLC we follow the potential changes to the taxation of investments very closely. We constantly try to provide investment returns in the most tax efficient manner possible. As the future tax laws become clearer we will use some or all of the techniques listed above to help our clients increase their wealth while reducing unnecessary taxes. If you would like us to review your situation our senior management team will be happy to work with you directly. Finally, you should consult your Certified Public Account or tax professional before making any changes to your finances.
