Preparing for Tax Hikes
Though many details are still fuzzy, Obama’s victory confirmed what many have predicted for a while: Taxes on the wealthy are set to rise. Here’s how to avoid a big tax bill
For investors, especially wealthier Americans, the victory of Barack Obama’s Presidential campaign has raised the fear of higher taxes.
Many pundits had already predicted that, regardless of the election’s outcome, taxes would be going up. The costs of two wars and other spending has ballooned the federal budget deficit just when the government faces rising entitlement costs from the retirement of the Baby Boom generation. Plus, a deepening recession hurts tax revenue at the same time the U.S. Treasury is in the process of spending hundreds of billions of dollars to bail out the U.S. financial sector. “It does seem a no-brainer to plan for taxes to be higher in the future,” says Thomas Rogers of the Portland Financial Planning Group in Portland, Me.
Obama actually proposes tax cuts on middle- and lower-income Americans, but he also campaigned on higher taxes on the wealthy—generally defined as couples earning more than $250,000 per year. Income-tax rates could be affected, as well as estate taxes and tax rates on capital gains and stock dividends.
Delays Are Possible
Many economists cringe at the idea that the government could raise taxes during a recession, but Washington experts say it has happened several times in the past, when recessions and falling revenue often inflate deficits. The best hope for tax-fearing investors may be that Obama and the Democratic-controlled Congress will delay tax increases.
Obama was asked at his first post-election press conference on Nov. 7 if he would proceed with his upper-income tax hikes. “I think the plan that we’ve put forward is the right one,” Obama said. “But obviously over the next several weeks and months, we are going to be continuing to take a look at the data and see what’s taking place in the economy as a whole.” He didn’t address a reporter’s query about whether tax changes would take effect in 2009 or later.
If Obama still must work out tax details with Congress and the members of his economic team, it’s hard for investors to know how to plan and protect against higher taxes. “Reacting to legislation that may or may not pass is a fool’s game,” says Bedda D’Angelo, president of Fiduciary Solutions, a financial planning firm in Durham, N.C. “Congress never does quite what you think it is going to do.” David L. Blain, president and chief investment officer at private wealth manager D.L. Blain & Co. adds: “Once we know what the rules are, we can plan for them. The biggest concern is we don’t know what the final result is going to be.”
Watch the Tax Tail
How worried should investors be about the signs pointing to higher tax rates? Certainly taxes can have a big impact on portfolios. According to a Morningstar (MORN) analysis, from 1926 to 2007, stocks gave a 10.4% return annually before taxes, but only a 8.2% return after taxes. Bonds’ 5.5% annual return in that time frame shrinks to 3.5% after taxes.
But the impact of taxes is not the same for everyone. D’Angelo notes many clients worry about taxes even though they’re not in a high tax bracket and wouldn’t be affected by Obama’s proposals.
When asked about the possible new tax rules, one financial planner after another repeated the truism: “The tax tail should not wag the investment dog.” In other words, don’t let a worry about taxes lead you to make foolish investment decisions that could hurt your long-term returns. One example, says Marilyn Bergen of CMC Advisers in Portland, Ore., is when investors hold onto huge
Harvest Tax Losses Now
In order to pay taxes, you need to make money—and, if a big payday means a big tax bill, maybe that’s a good problem to have in a time when many people are losing their jobs.
Still, no one likes paying extra to Uncle Sam. And, Blain says, “when you’re talking about a higher-income person, it makes a huge difference.” Some wealthy Americans, after all, could see some income taxed at a rate of almost 40% under Obama’s tax plan.
Whether taxes are headed higher in 2009 or not, many advisers suggest investors harvest tax losses before the end of the year. Capital gains taxes take a bite out of your gains, but the opposite—losses—can help minimize tax bills. Under the capital-gains tax, “the government essentially takes on part of the risk involved in equities,” Blain says. The government “can finance part of your loss.”
Which Account is Right?
So, with the stock market and other investments down substantially for the year, investors can sell investments and realize a loss that might be used to offset income elsewhere this year or in future years. One complication: IRS rules often prohibit buying back the same investment right away, so you might need to find a similar investment to replace the one you sold.
To prepare for higher taxes over the longer term, investors can carefully choose which investments are placed in tax-protected accounts, such as 401(k) plans and traditional individual retirement accounts (IRAs), and which are in taxable accounts. For example, gains and dividends from stocks are typically taxed under the capital-gains rate. For wealthy investors, this rate is lower than their regular income rate, even if the rate rises from 15% to 20%, as Obama has proposed. Therefore, it might be smart to put equities or tax-protected municipal bonds in a taxable account. Meanwhile, real estate funds or other bonds—the proceeds of which are usually taxed as regular income— might go in tax-protected accounts.
If you think tax rates are going higher, you might prefer to pay taxes now rather than later. Some planners advise moving investments from traditional IRAs (in which you pay taxes when you withdraw assets from the account) to Roth IRAs (in which you pay taxes when you deposit assets). However, these strategies are not right for all investors, and their suitability depends in part on what tax rate you expect to be paying during retirement. Accountants and financial planners can help do that complicated math.
One Last Chance
The tax threat is a hot topic in financial planning offices these days. Many advisers predict more demand for complicated tax protection schemes, including trusts, variable annuities, and life insurance plans. Sometimes these options come with high price tags in terms of fees and commissions, so it’s important to get impartial advice, Rogers says. “People need to be thoughtful and not get seduced by the sales pitch,” he says.
The last two months of 2008 give investors one last chance to make tax moves before possible increases in 2009. But it’s important not to make any foolish decisions you might regret. Make sure you actually would be affected by the proposed tax increases, and wait until legislation is passed before making any moves you can’t reverse. Seek professional help for the more complicated tax planning calculations.
Most important of all, advisers say, don’t make investing decisions solely based on their tax implications. Remember that the goal of investing is to make money, not just to avoid taxes.
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