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So Now What? Investment Planning in the New Tax Environment

The fiscal cliff debate resolution may have averted an acute crisis at the beginning of 2013, but it didn’t provide a long-term fix for the United States’ chronic imbalance of revenues and spending. The conversation has now shifted to the debt ceiling and how the mandatory spending cuts (known as the sequester) will be administered. Without a doubt, the country’s fiscal future remains cloudy and uncertain; however, the American Taxpayer Relief Act of 2012 (ATRA) does provide some fresh insight into the potential direction of future tax policy (see Figure One). While its impact will not be fully felt until this time next year, as taxpayers file their 2013 taxes, the time to plan is now. Our hope is that priming you with a few specific ideas will help you start conversations with your tax advisors. These are conversations you should have as soon as possible to help manage your income and, therefore, your 2013 tax picture.

 
This quarter we asked tax expert Chris Hennessey to provide his perspective on these recent developments. Chris is a tax attorney, certified public accountant, associate professor of law at Babson College, and advisor to Putnam Investments on wealth management topics such as tax, estate, retirement, and education planning. Chris recently joined us to answer questions and provide his thoughts on how CAPTRUST clients may want to adjust their thinking on a few topics to help manage their tax liability.
 
Q: In general, how would you describe the impact of the tax provisions that go into effect this year?
Hennessey: The vast majority of taxpayers will notice little to no change in their 2013 taxes. The big changes will primarily impact taxpayers at the higher end of the income scale — which the administration defines as more than $400,000 of taxable income for individuals or $450,000 for couples filing jointly. Without thought and planning, those taxpayers may see some fairly significantly increases. To put some numbers around the potential tax impact, taxpayers with investment income in the new highest federal income tax bracket go from paying 35% to 43.4% with the Medicare surtax included. But that’s not the whole story. With the phaseout of itemized deductions, you should anticipate another 1 to 2%, so the spread is more like 35% to 45% — about a 10-percentage-point increase. The potential increase for these people means that the cost of failing to plan has gone up.
 
Q: It sounds like reducing taxable income becomes a priority. Can you offer a couple of tax planning strategies for our readers to discuss with their tax advisors?
Hennessey: Taking advantage of pre-tax savings accounts is probably the best place to start. 401(k)s, 403(b)s, individual retirement accounts (IRAs), nonqualified deferred compensation, flexible spending accounts (FSAs), and health savings accounts (HSAs) all become more important in a higher-tax-rate environment. I suggest higher-income families take a look at how they might use these accounts to reduce their taxable income, ideally to get it below the thresholds for the Medicare surtax, itemized deduction phaseout, or new top-end tax bracket. The tax savings could be significant. For example, let’s take a look at a married couple with three children where both spouses work. The parents can max out their 401(k) plans for a total of $35,000. Then, they’ve got dependent care spending accounts for another $5,000, an HSA plan for $6,450 each, and, finally, FSA plans for another $2,500 each. That’s a lot of pre-tax savings, which will directly reduce their taxable income.
 
Another strategy involves managing the timing of gains and losses. I am not a fan of “rules of thumb” but, in the past, most tax advice suggested taking losses and deferring income and gains in an attempt to reduce current-year taxes. Today, it’s a slightly different and somewhat more complex challenge. It will be more important to time the recognition of gains and losses to try to manage income below these thresholds. Taxpayers will want to match gains and losses, if possible. They may even want to take gains sooner — to “fill up” a lower bracket — if they anticipate their income will be higher in future tax years. This might be due to the pending sale of a business, expected stock option exercise, or required minimum distributions. This isn’t radically different thinking, but it is something to be mindful of.
 
Speaking of required minimum distributions, there is a provision in ATRA that allows individual retirement account owners over the age of 70½ to avoid taxes on their IRA distributions by making a direct transfer from the IRA to a qualified public charity. There is an annual limit of $100,000 on these transfers.
 
Q: Changes like this always seem to affect some asset classes or investment vehicles more than others. Who are the winners this time?
Hennessey: There are some pretty clear winners. Municipal bonds are obvious ones. Their taxable equivalent yields go up with the higher tax rates. Additionally, the 3.8% Medicare surtax doesn’t apply to income from municipal bonds. Growth stocks and growth-oriented mutual funds may also be winners
since they are not intended to generate a lot of income. Dividend-paying stocks may be somewhat negatively affected since the top tax rate for dividends is 23.8% compared to 15% previously, but I think many investors are simply relieved that dividends won’t be taxed as ordinary income.
 
Annuities and life insurance potentially become more attractive under these new tax rules. Despite being funded with after-tax money, they offer tax advantages that might come in handy for investors who are looking to reduce their future taxable income.
 
Lastly, there are a number of strategies involving Roth accounts that may be worth exploring. Younger investors may want to set up a Roth account as a hedge against future higher tax rates. Others may want to consider a Roth conversion — or series of partial Roth conversions — to create a tax-free income source in retirement. Roths have some interesting features that make them fairly flexible for tax planning purposes.
 
Q: I know you don’t have a crystal ball, but I’m sure you have an opinion. What is your outlook for taxes and tax reform?
Hennessey: It is very hard to predict these things, but a couple of things seem clear. Although this new law makes many formerly temporary tax rates and provisions permanent, it is still prudent for investors to prepare for a rising tax environment. Taxes are still relatively low by historical standards. Revenue as a percent of GDP is currently about 15.3%. Historically, that number has been around 18.5% — which might suggest that tax rates can go higher.
 
Second, given fiscal pressures in the U.S., it is very conceivable that additional legislation to address the federal budget deficit will be considered until we address mandatory spending on entitlement programs like Social Security, Medicare, and Medicaid. Against this backdrop, tax diversifi cation, and tactical, tax-smart planning strategies and investment solutions will be critical.