In December 2010, Congress extended the so-called Bush-era
tax cuts. However, for investors, the legislation may have been a stay of
execution rather than a full pardon. As of January 1, 2013, federal tax rates
on income, qualifying dividends, and capital gains (among other provisions) are
scheduled to revert to previous levels.
Given recent partisan wrangling, no one can be completely
sure about precisely what will happen. Even if all the scheduled changes don't
ultimately go into effect, others likely will. In the meantime, as the clock
ticks closer to some sort of decision point, it might make sense to review your
portfolio and do some "what-if" planning for various scenarios. Taxes
obviously are only one factor--and not necessarily the most important one--in
decisions about your portfolio; think of this as a chance to fine-tune your
You'll want to pay attention to scheduled changes in tax
rates, especially if your income is more than $200,000 a year ($250,000 for you
and your spouse, $125,000 if married and filing separately). Absent further
action, current tax rates will be replaced by five federal tax brackets rather
than six (see table) and the top long-term capital gains rate will go up.
If you're considering selling an asset that has appreciated
substantially, determine whether you should do so this year rather than next.
Even if some current income tax rates are extended, individuals or households
with incomes above the $200,000/$250,000 limits might still face higher rates.
If you're above the threshold, you could be hit simultaneously with a higher
capital gains rate on the proceeds of your sale and a higher income tax rate.
Don't forget the alternative minimum tax in your
calculations. Although the AMT doesn't apply directly to long-term capital
gains and qualifying dividends, they're included when calculating your taxable
income under the AMT. If realizing a large capital gain indirectly increases
your AMT exposure or might push you into the phaseout range for AMT exemptions, that could potentially wipe out any tax savings from selling this year.
If you think an investment will continue to be a sound one
but feel you would benefit from selling prior to 2013 to take advantage of
current low rates on existing gains, you could sell the investment and
repurchase it later. That would give you a higher cost basis for any subsequent
sale, potentially reducing your tax liability at that point. Also, even if you
do decide to sell, you don't necessarily need to do so all at once. The tax
cuts that produced the current rates have already been extended once, and it
could happen again. Repositioning your portfolio gradually could moderate the
risk of a single badly timed sale. There also are a variety of strategies for
managing concentrated stock positions; get expert help before deciding that
selling is your only choice.
There's another reason the scheduled tax bracket changes are
important. As of 2013, qualifying dividends are scheduled to be taxed as
ordinary income, as they were before 2003, rather than at the lower rate for
long-term capital gains. The higher your tax bracket and the more you rely on
dividends for income, the more you should be aware of the potential impact of
that change on you.
However, remember that taxes aren't the only factor you
should consider in making a decision. Dividends can still represent a welcome
income alternative to interest rates that are expected to remain at rock-bottom
levels through mid-2015. And with baby boomers beginning to reach retirement
age, interest in any and all sources of ongoing income is unlikely to
disappear. As with capital gains, many factors will affect your decision about
the role of dividends in your portfolio.
Current and New Federal Tax Rates 2012 As of January 1, 2013
Ordinary income 10%, 15%, 25%, 28%, 33%, 35% 15%, 28%, 31%,
Capital gains (generally) 15% maximum; 0% for those in 10%
and 15% income tax brackets 20% maximum; 10% for those in 15% income tax bracket (slightly lower rates will generally apply to a sale or exchange of
assets acquired after December 31, 2000 and held for more than five years)
Qualified dividends Taxed at long-term capital gains rate
(15% top rate) Taxed as ordinary income (39.6% top rate)
Medicare contribution tax on unearned income N/A 3.8% on net
investment income for individuals with MAGI over $200,000 ($250,000 for married couples filing jointly; $125,000 for married individuals filing separately)
Investment income/payroll taxes
There's another factor you may need to be aware of.
Beginning in 2013, a new 3.8% Medicare contribution tax will be imposed on some or all of the unearned income of individuals with high modified adjusted gross incomes (see table). Also, the hospital insurance portion of the payroll tax is scheduled to increase by 0.9% for higher-income individuals. However, unless
you exceed the specified thresholds, neither provision will affect you.
If you expect to be affected by the new taxes and/or a
higher tax bracket, the benefits of tax-free investments might become even more pronounced. Taxable bonds typically pay higher interest rates than municipal bonds, but if you're in a high tax bracket, munis can potentially offer a better after-tax return. As with any investment decision, there are many
factors to consider. Local and state governments have come under severe
financial pressure, and though the default rate on munis has traditionally been
low, a default is always possible. Also, interest rates have been at historic
lows since the end of 2008; since bond prices move in the opposite direction
from their yields, rising interest rates would not be good news for bond
Good time for a checkup
If you do decide to make adjustments, this year will require
a tradeoff in timing them. Postponing action may give you more clarity, but
waiting until the last minute could potentially leave you caught in a stampede
for the door at year's end, or trying to make decisions during a volatile
period. If you decide to sell, make sure you've allowed enough time to
accommodate trade settlements and holiday schedules.
Investments in tax-deferred accounts, such as IRAs or
401(k)s, won't be affected by any tax changes until you withdraw the money, so
unless you're contemplating the timing of a withdrawal, you may not need to
worry much about them. However, if you've been considering a Roth IRA
conversion, find out whether you would reduce your tax liability by converting
in 2012 rather than later.
Even if 2013 seems unlikely to have much impact on you, this
could be a good time for some routine portfolio maintenance. And if you think
you might be affected by any of the above situations, it's especially important
to get expert help.
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provide investment, tax, or legal advice. The information presented here is not
specific to any individual's personal circumstances.
To the extent that this material concerns tax matters, it is
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