By: Richard Feldman, CFP, MBA, AIF
The number-one drag on investment results is taxes, and you can be sure that taxes in the future will be going up given the amount of money that is being spent to get the economy back on track as well as big government initiatives that include health care.
The questions individual investors should be asking themselves are how will tax policy look in the coming years and how can I shape my investment portfolio and financial planning decisions to keep more of what I make in the investment markets on an after-tax basis.
2010 Tax Brackets
Each year group experts try to determine the coming year’s tax brackets based on a number of officially released statistics by governmental agencies to project and extrapolate the upcoming year’s tax brackets. The Tax Foundation which is a Washington, D.C.-based think tank and a number of other groups that operate under the auspices of the Wall Street Journal have consistently released very accurate projections of the coming year’s income tax rates well in advance of the official IRS releases.
Given the sluggish economy and very low inflation rates for 2009 the Tax Foundation and other associated experts are predicting very little change for the 2010 federal tax brackets, standard deductions, personal exemptions, and even retirement account contributions limits from 2009. To follow are the projected federal tax brackets in 2010:
Personal Exemption: Will stay unchanged at $3,650;
Standard Deduction: The standard deduction for married couples filing jointly will remain unchanged at $11,400 and for single filers will remain at $5,700;
Annual Gift Tax Exclusion Amount: For 2010 the exclusion will remain at the 2009 level of $13,000;
Traditional and Roth IRA Contribution Limits: The standard IRA contribution limit for 2010 will remain unchanged.
Tax Policy in 2011
As we can see, there is not much happening on the tax front in 2010. It would be difficult for President Obama to tackle healthcare and the banking system and raise income taxes all in the same year when the economy is still weak and unemployment is at 10%. The question then becomes what is going to happen to tax rates in 2011 after George Bush’s tax cuts expire? I am pretty sure that everyone already knows the answer to the question but I will quantify what Grant Thorton thinks the federal tax brackets will look like in 2011:
* Current federal tax brackets will go from 10%, 15%, 25%, 28%, 33% and 35% to 15%, 28%, 31%, 36%, 39.6%;
* Capital gains tax rates which are currently 0% and 15% depending on AGI will go back to the 10% and 20% pre-Bush tax rate cuts;
* Qualified dividends now taxed at the lower capital gains rates will once again be taxed at the higher ordinary income tax rates which could be as high as 39.6%.
The increase in federal tax rates referenced above is a big reason that some individuals are choosing to convert their Traditional IRA account into a Roth IRA and pay the income tax now at lower tax rates. The federal government in 2010 is allowing taxpayers who convert to a Roth IRA to spread the income over the 2011 and 2012 tax year equally, but if you convert a large enough IRA it might make sense to pay all of the tax in 2010 if enough of the conversion might be taxed at a 39.6% tax rate versus a top marginal tax rate of 35% in 2010.
Tax Loss Harvesting
Realized and unrealized capital gains for high tax bracket filers will become more valuable in 2011 if capital gains rates are indeed raised from 15% to 20%.
Investors who have taxable accounts should look at their portfolio and see if there are any capital losses that might be realized. Selling your losers or booking tax losses now can help you offset the future tax liability created when you sell an investment at a gain. Investors in high federal and state tax brackets should try and offset short term gains if possible.
Short-term capital gains are taxed at an investor’s ordinary income tax bracket which can be as high as 35% currently. Typically, short term gains and losses are netted against one another as are long term gains and losses. After the initial netting of short and long term losses, the two are then netted against one another which will leave you with either a short term or long term gain or loss.
Again, it is beneficial to try and end up with a long term gain rather than a short term gain due to the disparity (up to 20%) in the tax rates on short and long term gains. If you end up with a loss, either short or long term, $3,000 of that loss can be used to offset ordinary income. A $3,000 loss will save you approximately $840 in taxes assuming you are in the 28% bracket.
With the advent of Exchange Traded Funds tax loss harvesting has become much easier. If you wanted to take a loss in any particular asset class you could sell the mutual fund and replace it with the corresponding exchange traded fund for 31 days and then move the assets back. This will allow you to maintain the integrity of your asset class exposure.
Portfolio Allocation Decisions
The change in tax law will also bring into play tax location strategies in terms of where investors place different asset classes. Most investors have tax deferred (401(k)s, IRAs, and Roth IRAs) as well as after tax accounts. Depending on the tax characteristics of various investment asset classes investors can choose which account to hold investment assets in.
A lot of investors moved money out of fixed income in their taxable accounts and instead bought high dividend paying stocks because they would only be taxed at 15% on qualified dividends rather than ordinary income on taxable bond interest. In 2011 there is a very high chance that dividends will once again be taxed as ordinary income and that could be as high as 39.6%.
Taxes play an important part in our investment decisions and financial planning process. It is wise to start making financial decisions and implementing investment strategies ahead of the tax increase that is sure to come in 2011.