As many people are aware, we are facing the pending expiration of former President Bush’s numerous income tax cuts. If Congress doesn’t act before year-end, many of these tax reductions will lapse, and consumers will face a new and harsher tax reality. Additionally, the tax changes built into the Health Care Reform Act will produce tax increases in future years, disproportionately higher for investment income.

At present, we’re looking at a huge amount of uncertainty. No one can accurately predict what Congress will do, much less what Congress will look like after November  2, so consumers are left to prepare their finances for what might occur.

Let’s assume that Congress allows the tax cuts to expire in January, what should taxpayers do to prepare their finances for the new tax environment?

Early Tax Payments

For starters, if tax rates go up, it might make sense to pay some tax early by accelerating some income into 2010, or deferring deductions until next year. Normally, we have to compare the benefit of the lower tax rate with the disadvantage of paying the tax earlier and losing the time value of the money with which we pay the tax. However, in the current interest rate environment (i.e., practically nonexistent for cash), the opportunity cost of paying tax early is negligible. 

Dividend Taxation

If Congress does nothing, the biggest tax increase will be on dividend income. The Bush tax cuts took dividend tax rates from the level of ordinary income down to the same rate as the capital gains tax, which was unprecedented. If the cuts lapse, dividend income will lose its preferential tax treatment and be taxed again at ordinary rates, which are scheduled to increase to 39.6 percent, a 24.6 percent increase. Does that mean a person should change how they are allocating his or her investment portfolio? Not necessarily. Tax-aware investing does not mean that we let the tax tail wag the investment dog. At present, many believe that high quality companies with healthy and increasing dividends are especially attractive. Many of these companies are defined by low leverage, stable and growing revenues, and lean and cash-rich balance sheets due to drastic cost cutting in recent years. Both the fundamentals and the tax treatment need to be taken into consideration when thinking of making changes in your portfolio because of tax law changes. 

Capital Gains Rates

If the cuts expire, short-term capital gains rates will go up to 39.6%. So the pay-off for selling long-term appreciation as opposed to short -term is more pronounced. Investors would be wise to look at portfolio turnover rates when choosing equity managers. You want a manager who is aware that an appreciated stock, which he or she is thinking of selling, is a week or two away from having a long term holding period. Also, a manager who might harvest tax losses at year-end to offset realized gains in the portfolio will reduce your tax bill.

The long-term capital gains rate also increases if the Bush cuts lapse, from 15 percent to 20 percent. This means that wise use of capital-loss carryovers produces greater value in future years.  Many investors find (if they study their tax returns) that they have excess losses carrying forward from the recent difficult years. In this case, net capital gains can be sheltered to the extent of those losses. This might provide an opportunity to take some appreciation off the table in some positions that have done well. If losses are allowed to carry into 2011, they will be more valuable as the rates increase next year.

Mutual funds can produce an unfortunate anomaly in the case of short-term gains. If a fund has net long-term and short-term capital gains inside the fund, the long-term gains are distributed and subject to long-term capital gains rates. In the case of net short-term gains; however, they are distributed and treated as ordinary income. Therefore, they cannot offset capital losses, either from the current year or from loss carryovers. This is another reason to be aware of the trading strategies inside the mutual funds that you choose. If performance is good enough, you will not mind paying an additional tax bill. But the bar is set higher to get good after-tax returns.

At Signature, we reach out to mutual funds that we invest with in order to get a sense of their realized long-term and short-term capital gains for the year. Mutual funds generally distribute the bulk of their capital gains at the end of the year. Occasionally, an analysis will indicate that it is more tax efficient to sell the fund, when held for more than a year, and pay long-term capital gains tax on the total appreciation rather than to receive the short-term capital gain distribution and pay ordinary rates on it.

A good rule of thumb that has not changed is to avoid purchasing mutual funds at the end of the year before they have made their capital gains distributions. You will get capital gains distributions that were really other people’s appreciation and be required to pay tax on it even though you didn’t hold it during that time. During periods of higher taxes, this becomes more painful.

Taxable & Nontaxable Accounts

In a higher tax-rate environment we are more likely to allocate an investment portfolio across taxable and nontaxable accounts. As tax rates go up, there is more payback for putting less tax-efficient assets into an IRA and more tax-efficient assets into a taxable account.  Some of the asset classes that are getting more attention these days, commodities, fixed-income trading strategies, alternatives, etc., are less tax-efficient than the old-fashioned buy-and-hold stock and bond funds, and are therefore better suited for your IRA or 401(k). This allocation strategy can cause some rebalancing or distribution complications, but the payback for your trouble is higher when rates are higher.

Alternative Minimum Tax

The Bush tax cuts pushed a lot of taxpayers into the AMT, causing them to lose the benefits of many of their deductions. If the Bush tax cuts are allowed to expire, ordinary income tax rates will go up, and fewer taxpayers are likely to be in an AMT position. In this situation, i.e., in AMT in 2010 but not likely in 2011, it might be worthwhile to defer some deductions, particularly miscellaneous itemized deductions like manager fees, property taxes and even state income taxes to 2011. When planning for the alternative minimum tax, we recommend performing a two-year side by side analysis, especially if the years are dissimilar due to significant taxable events or other life changes.

Tax planning has probably never been more difficult because of the uncertainty. All of the above assumes that Congress does nothing. Prognosticators are betting the Republicans take some seats in November, and the Democrats have six more weeks after elections to do something…or nothing.  We have provided you with some tips that should add value for you if Congress does not extend the cuts, and if they are extended, these tips will do little or no damage. If nothing else, the fall of 2010 will be an interesting season to have ringside seats for the tax legislation process.

Susan Colpitts executive vice president and co-founder of Signature, a family office with $2 billion in assets, located in Norfolk, Va. Colpitts provides investment advice and heads the technical areas of financial planning, tax, trust and estate administration at Signature.