Senior Vice President | CAPTRUST Financial Advisor
As a child of two hardworking parents who ran a retail shop, I had to choose between scouting, other extracurricular activities, and my beloved team sports due to the demanding nature of the family business. The latter prevailed, but luckily, because many of my teammates also participated in scouting, I picked up some secondhand exposure to fundamental Boy Scout practices and traditions. I remember their long-standing motto, “Be Prepared,” which encourages the importance of understanding your situation and how it might change, maintaining a mentality of being ready to react.
The current uncertainty we face with our income tax laws, the so-called “taxmageddon,” is a good reason to think like a Scout throughout the remainder of 2012. While it is impossible to know the ultimate outcome, it is possible to understand and prepare for potential outcomes and evaluate actions that may make sense depending on your individual circumstances.
Several potential scenarios exist, including expiration or extension of the Bush-era tax cuts, adoption of proposed legislation (like President Obama’s proposed budget), and introduction of completely new legislation. Additionally, the recent Supreme Court ruling on the constitutionality of President Obama’s Patient Protection and Affordable Care Act (PPACA) adds tax considerations. Many worry that political intractability will lead to gridlock and that nothing will occur prior to year-end. By default, taxpayers would face pre-Bush-era tax policies in 2013 and possibly PPACA taxes as well.
Specifically, if the Bush-era tax cuts expire, expect three primary impacts on 2013income taxes:
• The maximum rate on ordinary income would increase from 35% to 39.6%
• The maximum rate on qualified dividends would increase from 15% to 39.6%
• The maximum rate on long-term capital gains would increase from 15% to 20%
If the PPACA taxes come along for the ride in 2013, the tax effect would become foreseeably worse. If this were to actually happen, the maximum rates for qualified dividends and long-term capital gains would effectively be 43.4% and 23.8% respectively, due to a new 3.8% Medicare tax on investment income for those with Adjusted Gross Income (AGI) over $250,000.
The challenge of being prepared is complicated by the need to think in ways sometimes contrary to a more traditional approach. For example, as year-end approaches, we traditionally look to “harvest” capital losses that can be used to offset realized capital gains. In Client accounts where we have investment discretion, this goal is implemented in different ways, including taking steps to avoid material capital gain distributions from mutual funds. However, if higher rates seem likely in 2013 and beyond, one might take the opposite approach and choose to have a long-term gain taxed at 15% in 2012 and save the capital losses for the future, where they have more value against higher rates. The answer is likely different if the realized capital gains are short-term and using available losses as an offset will make sense.
Another call to action may lie with ordinary income, where an element of control over timing exists. Some examples are the exercise of nonqualified stock options, Roth IRA conversions, and bonus payments. The ordinary income from a stock option is triggered at exercise, and the timing of that exercise is up to the option owner. The lever here is the expectation of the tax rate for ordinary income being higher after 2012. As previously noted, the expiration of the Bush-era tax cuts alone will increase the maximum marginal rate on ordinary income by 4.6%; additionally, if the PPACA taxes survive, we add another 0.9% to Medicare payroll tax for income levels over $250,000. Paying taxes at a rate 5.5% lower might motivate accelerated stock option exercise in 2012.
While a bit less time-sensitive, potential tax rate increases may require evaluation of how investment portfolios are constructed. For example, if we have higher marginal rates on ordinary income, municipal bonds’ tax advantage may increase. Similarly, if dividends’ preferential tax treatment is lost, those seeking portfolio income may need to find more efficient ways to achieve this goal.
And there are even more potential rule changes. The pre-Bush-era tax policy applied an 18% long-term capital gain rate to a security purchased after January 1, 2001, that has been held more than five years. This rule will re-apply in 2013 if the Bush-era tax cuts are allowed to sunset.
In conclusion, the uncertainty surrounding the future course of U.S. tax rates could be likened to packing for an adventurous camping trip without knowing the destination’s weather forecast. I believe my loyal Boy Scout friends’ advice would go something like this: Be prepared for multiple environmental conditions and anticipate unforeseen situations that may require skilled action. Such advice is helpful as we wait for electoral outcomes and future legislation to unfold, revealing a set of more definitive conditions.