Investors and advisors often turn to tax planning only during the fourth quarter, but such tunnel vision may prove to be a mistake in 2012.
Unless Congress takes action before year-end, the 2001 Bush tax cuts will expire on December 31-pushing the top income tax rate in 2013 up to 39.6% (from 35%); the rate on long-term capital gains to 20% (from 15%); and eliminating the preferential 15% rate on qualified dividends altogether. In addition, a 3.8% surtax on investment income in excess of $200,000 will take effect in 2013.
For clients with substantial investment income, the effects will feel Draconian. Worst-case scenario: The marginal tax rate on qualified dividends-those paid by most U.S. corporations-could jump as high as 43.4%, almost triple the current 15% rate. And long-term capital gains will be taxed at 23.8%, up dramatically from today's 15%.
The optimum tax strategy for 2012 may be counterintuitive. For years, advisors have told clients to defer income and accelerate deductions to minimize their tax liability for the current year. If Congress does not act-or if it does, but tax rates still go up in 2013-it may make sense for clients to do the reverse: Accelerate income while rates are low and defer deductions that will be more valuable when rates are higher.
"Wealthy investors should look at taking gains earlier in the fall," says Baker Crow, a trust officer in the Birmingham, Ala., headquarters of Regions Financial, a $130 billion commercial bank. "If there is a fear these taxes will be imposed, you could see December be a down month."
Selling pressure could push equity prices down in December if people want to lock in the lower, long-term capital gains rate this year, he says. "People will take gains to avoid extra tax in 2013, so it could artificially drive down prices for a time."
Clients who have held highly appreciated stock for a long time, for example, can sell this year to lock in a 15% tax rate on the gain. "If they feel good about the security and still want to own it, we will put the proceeds into an ETF that is similar and then buy the original stock back once the wash-sale period is over," Crow says.
Taxpayers in the top tax bracket get the biggest benefit from the preferential 15% tax rate on qualified dividends too. Mutual funds and exchange-traded funds are conduits for tax purposes. That is, they have no separate existence as far as the IRS is concerned. The tax consequences of any trading they do and the dividends or interest they receive flow straight through to the shareholder of the fund in a pro-rata basis.
Nevertheless, Crow points out that clients need to be careful about the timing of fund purchases. Most funds distribute capital gains only once a year, and while some funds distribute dividends every month, others do so quarterly or annually. A client who puts money into a fund shortly before it makes a substantial distribution will owe tax on the full amount paid out. "If you buy a mutual fund in December and it realized substantial gains during the year, you will be taxed on those gains even though you did not benefit from them," says Crow. "Timing is important."
Although advisors and their clients have to consider the tax implications of every investment, taxes never drive the investment process-or shouldn't. Crow says clients must first evaluate why a particular investment is attractive and how it fits into their portfolio before they look at the tax implications.
But attitudes toward taxes can interfere with dispassionate analysis.
Matthew Smith, a portfolio manager in the wealth management division of Regions Bank says clients sometimes hold on to concentrated positions that are underperforming the market or even declining in value just to avoid realizing a capital gain. "That makes no sense," he says, "particularly when capital gains are taxed at a lower rate than ordinary income."
Some clients go to the opposite extreme: They ignore the tax implications of their investments altogether.
Rex Macey, chief investment officer at Wilmington Trust, a subsidiary of $78 billion Buffalo, N.Y.-based M&T Bank, has seen people invest in complex vehicles like hedge funds without considering the effect on after-tax returns. "I have also had clients say they would rather flush money down the toilet than give it to the government," he says. "People are irrational when it comes to taxes."
Wilmington's clients skew toward ultra-high-net-worth individuals, but no two clients are in the same tax position.
For example, some have almost all their money in tax-deferred accounts like traditional IRAs and 401(k)s. Although these clients care about tax rates in later years when they have to take distributions taxed as ordinary income, taxes generally don't affect their investment strategy during the accumulation phase. Other clients may have sold a business and have their assets concentrated in taxable accounts, while still others have a mix of taxable and tax-deferred assets, and perhaps a tax-exempt Roth IRA.
"Clients with large taxable accounts are the most sensitive to taxes, but those with the most moving parts are the most complex," says Macey. "We also have clients who are financially immortal, whose money will outlast them without a doubt. They can avoid capital gains taxes altogether by buying and holding stocks and ETFs."
For mere mortals, however, Macey recommends harvesting losses in taxable accounts throughout the year rather than waiting until year-end, a strategy that enables clients to reap some benefit from market volatility.
The most tax-sensitive clients of all may be those who receive income from trusts.
Lee Sorenson, a regional financial planner in the Private Client Reserve group at U.S. Bank Wealth Management, notes that for irrevocable trusts higher tax brackets kick in at a much lower threshold-the top marginal rate of 35% applies to trust income in excess of $11,350 in 2011, compared with $379,150.
At the opposite extreme, consider charitable foundations, which pay no tax at all. Since they don't pay taxes, investments that minimize taxes, like most municipal bonds, are not suitable for those types of accounts.
But advisors still can't ignore the tax characteristics of investments. "Taxes come into play no matter what," says Sorenson. "It is not the first thing a client should look at but it is a close second." (There are some extreme cases when such accounts may well buy tax-exempt investments, such as when the muni market got hit so hard last year and investors made substantial capital gains. So much so that it could have made sense even in a tax-deferred account. But that's the exception, not the rule.)
Call It a Deferment
Another point that clients need to be clear of is the difference between tax deferrals and tax avoidance. It's a distinction some people fail to grasp, but an important one. Deferral simply staves off the tax liability until a later day. It is essentially an interest-free loan from the government in that it enables investors to compound the investment gains without paying taxes immediately. The account holder is able to accumulate more money and then pay taxes at prevailing income tax rates in the future.
On the other hand, avoidance occurs when an asset is held by a tax- exempt account-a Roth IRA or foundation, for example-or a client holds an asset until they either give it away or die. In this case, the recipient or heir gets a stepped-up tax basis equal to fair market value at that date. This way, any capital gains on appreciation that took place during the lifetime of the deceased client are wiped out for tax purposes.
This alleviates heirs from the burden of establishing a tax basis for securities that may have been bought decades earlier.
Essentially, the tax man never sees a penny no matter how much the asset has appreciated beforehand. "If you can hold a stock or ETF forever and get the step-up in basis, that's huge," says Macey at Wilmington Trust. "If you defer for a long time, that's great, but if you defer just a few years it won't affect you very much."
Clients can mitigate the effect of current and deferred taxes through careful placement of assets.
Adonis Caneris, a senior wealth planner at Haberer RIA, a subsidiary of $55 billion Columbus, Ohio-based Huntington Bancshares, recommends that retirees or people close to retirement hold income-producing assets in tax-deferred accounts and equities in taxable accounts. It's a tax rate play: Qualified dividends and long-term capital gains are taxed at a modest 15%, while interest suffers the full marginal income tax rate-up to 35% in 2012. Clients approaching retirement may anticipate a lower marginal tax rate when they stop working and start taking distributions too.
Younger clients may prefer to put equities into tax-deferred accounts to maximize the compound growth potential over a long period, however. "Age is relevant to the discussion and the investment objective-how risk averse they are," says Caneris.
The AI Advantage?
Alternative investments like master limited partnerships (MLPs), private equity, real estate or hedge funds have important tax ramifications too. A master limited partnership often generates unrelated business income, as do some hedge funds. In either case, a tax-deferred account that received this income would become taxable-blowing the whole tax strategy. "Many clients are looking at alternative investments," says Caneris. "We have to help them understand the tax implications of placing them in a tax-deferred vehicle versus a taxable account."
Limited partnerships and REITs sometimes generate passive losses, which taxpayers can offset against other passive gains-but not against ordinary income or regular capital gains. "For investments that report their income on a K-1 [a partnership, for example], you may not know what is going to come through at the end of the year and how it will affect your tax return," says Sorenson at U.S. Bank. The tax complexity of these investments usually means they are best held in taxable accounts.
Other nontraditional investments are more suitable for IRAs or 401(k)s, however.
For example, zero coupon bonds are sold at a discount to par and pay no interest. Yet the IRS treats the accrual of the discount as taxable income even though the holder receives no cash. And Treasury Inflation-Protected Securities (TIPS) have a similar characteristic: The IRS considers the inflation adjustments that accrues to principal each year as taxable income but the holder receives only the coupon interest rate. If inflation is high, the cash received may not even cover the tax due, which is levied on both the coupon and the growing principal. "Clients end up paying taxes on income that isn't immediately received," explains Sorenson. Placing these assets in tax-deferred or tax-exempt accounts eliminates the immediate cash drain.
If clients have Roth IRAs, advisors often steer them toward assets that have the greatest potential for capital appreciation. The money that goes into a Roth IRA has already been taxed, so withdrawals are tax-free-and the bigger the balance grows, all the better.
The designated beneficiary of a Roth IRA doesn't pay any tax, either upon transfer of ownership or when taking distributions. "Roth IRAs are a great vehicle for transferring wealth between generations," says Caneris at Haberer RIA.
IRAs-whether traditional or Roth-do not count as part of a decedent's estate for tax purposes, passing directly to the beneficiary without going through probate. For wealthy clients potentially subject to the estate tax, 2012 may be a good year to give away assets to reduce the size of their estate. The unified lifetime gift- and estate-tax exemption-$5.12 million in 2012-is the highest it has ever been, but will drop to just $1 million in 2013 under current law.
Congress may well enact a higher exemption before then, but election-year politics dictate that legislators will likely do nothing until the November elections. "If a client can move an asset that is expected to appreciate to an heir at a relatively low gift-tax rate-or none at all-then all the appreciation will be for the recipient's benefit," says Michael Campbell, a tax partner in the San Francisco office of accounting firm BDO Seidman. "That will reduce the donor's exposure to the estate tax."
He sees estate-tax planning as a balance sheet exercise, creating an investment portfolio that will generate enough income to maintain a client's lifestyle but attract little or no estate tax, while shifting growth-oriented assets to the next generation through gifts, trusts and other techniques.
Clients wealthy enough to be subject to the estate tax when they die usually pay income tax at a high marginal rate too.
For people in the top tax bracket, municipal bonds may be attractive because the interest is exempt from federal income tax (except for Build America Bonds, which are taxable to investors). Most states exempt interest on municipal bonds of in-state issuers from state income taxes too.
But the decision to buy municipal bonds rather than taxable corporate or Treasury bonds isn't always a slam- dunk.
Once an investor does the math, the yield on a taxable bond is sometimes higher than the tax-free bond. "People look at the after-tax yield on taxable bonds versus munis," says Campbell. "It is often easy to choose one over the other."
Would that it were as easy to navigate the tax turmoil advisors and investors alike face in 2012. With careful planning and extreme vigilance on an ever-changing tax scenario, though, diligent advisors can find the right path for clients to take.