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Asset Location Strategies – New Tax Laws May Mandate Change

By: Richard Feldman

You can improve your after-tax rate of return significantly by allocating your investment capital efficiently. The current tax law has made the question of where to hold assets a lot more important to individual investors because the spread between the highest ordinary income tax bracket (35%) and dividends/long-term capital gains (15%) is rather large at the current 20% difference. Effective placement of your investment assets can make a dramatic difference in your after tax rate of return leaving you with significantly more funds for your retirement.

For some Americans allocating investment assets across tax-deferred and taxable accounts is not a primary concern. If you are one of those individuals whose primary savings vehicle is their 401K, 403B, 457, IRA, or other tax-deferred vehicle, then planning is relatively simple. You devise an asset allocation model that meets your risk tolerance (75% equities and 25% fixed income) and you invest your plan according to those parameters.

But for most individuals or families this scenario is not the norm. Individuals often have retirement accounts, IRAs, Roth IRAs, taxable accounts and throw in a 529 plans and you are left with the difficult decision of what goes where.

New Investment Income Surcharge

The recent decision by the Supreme Court to uphold the 2010 Health Care Act made it clear that taxes on investments will be going up next year for high income individuals and families. The tax will affect anyone with Modified Adjusted Gross Income of more than $200,000 for individuals or for married couples with MAGI greater than $250,000.

The calculation of the tax is rather complicated but the rule states that the 3.8% surtax will be assessed on an amount over the thresholds but the actual tax will be imposed on the lesser of net investment income or the amount of MAGI over the above referenced thresholds.

Individuals with MAGI below the thresholds will not be affected by the surtax.

 

Qualified Dividends

Under current tax law qualified dividends that are paid out from corporations are taxed at 15% regardless of the individual or married couple’s adjusted gross income. If the Bush tax cuts elapse at the end of this year dividends will go back to being taxed at the filers adjusted tax bracket which could be as high as 39.6%. If you exceed the income limits referenced above you can add in the new 3.8% surtax on investment income and your tax rate on corporate dividends might be as high as 43.4%. In addition if you live in a State that has an income tax you on investment income you can add that in as well. If you add everything up and there is no compromise politically regarding the fiscal cliff, these tax rates will increase 189% excluding State Income tax effects. Dividends have been a popular way to obtain income in taxable accounts particularly with the collapse of current interest rates. Holding dividend paying equities in taxable accounts for high income earners would need to be rethought at a 43.4% tax rate.

Capital Gains

Under current tax law long term capital gains investments are taxed at 15% but should the Bush Tax cuts expire the rate would revert to 20%. In addition for high income households the 3.8% surcharge on investment income would be added to the 20% rate and your total tax on long term gains would be taxed at 23.8% for an increase of 59% over prevailing rates. Another current strategy was to hold low dividend paying equities in taxable accounts in order to qualify for the 15% long term capital gains rates rather than having those gains accrue ordinary income tax rates in tax deferred accounts (401Ks, IRAs, 403Bs). That strategy will need to be evaluated if capital gains rates go up to 23.8%.

Future Tax Law

There has been a lot of speculation that some sort of compromise will be reached on the Bush Tax cuts due to the current Economic situation in the United States. Investors with taxable assets should watch the current debate closely because if the Bush tax cuts do lapse and you throw in the new taxes on investment income that are coming on line in 2013 there will need to be substantial changes in how asset location strategies are devised.

In addition the one thing that is certain to occur in 2013 is that the new 3.8% surcharge will come online in 2013. If you are close to the limit of $200,000 for individuals or $250,000 for married filers than you will want to do some planning to make sure you stay under the limits if you have taxable investment income. Municipal Bonds would be a lot more attractive in taxable accounts and dividend and equities with capital appreciation potential would be better served being held in tax-deferred vehicles if you are close to going over the thresholds. You might also think about increasing your deferral into qualified plans to hold down your income. You can currently defer up to $17,000 into your 401K retirement account but not a lot of individuals take advantage of the utilizing the full $17,000.

In addition if you are thinking about doing a Roth Conversion you would be well served to execute this strategy in 2012 rather than 2013 and beyond. Particularly if the Roth Conversion would put your adjusted gross income higher than the thresholds for the new investment income tax of 3.8%.

Please contact your financial advisor or tax professional regarding these issues addressed above in order to see if they might be applicable to your current situation.