Planning for Rising Income Taxes: What You Earn vs. What You Keep
June 30, 2010Higher taxes are coming! Beginning January 1, 2011 most taxpayers will see their marginal federal income tax, capital gain and dividend rates increase between 13% and 164%. Although those increases are noteworthy, the upcoming dividend and capital gain rates are still lower than the 40 year period from 1940–19801 (see Chart A).
Chart A
To proactively prepare for these higher taxes, a phone call to your CPA should be a top agenda item in the coming months … and for years to come as the revenue provisions contained in the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act (the Health Care Act) will result in even more taxes for many families beginning in 2013.
How the Health Care Act Impacts Income Tax
A 3.8% Medicare surtax on net investment income (dividends, interest, capital gains, rents, etc.) will affect married couples earning more than $250,000 and single taxpayers earning more than $200,000 starting in 2013. The threshold for trusts is currently $11,200. Couple this surtax with the 2011 tax hikes, taxpayers could face a 189% increase in the federal income tax rate they pay on dividend income in less than 3 years (see Chart B). Also beginning in 2013 high income earners will see their Medicare hospital insurance tax increase from 1.45% to 2.35% (the employee portion only). Although deferring income into a nonqualified deferred compensation plan is one strategy to reduce taxable wages and minimize the surtax impact on investment income, in most cases it won’t escape the 0.9% Medicare surtax.
Chart B
Investment Planning Strategies for the Tax Increases
A prudent investment strategy should include elements designed for liquidity, income, and an engine for growth. For some investors, higher growth rates may be needed to overcome the tax increases to maintain one’s standard of living, or keep them on track for meeting future financial goals. Portfolio growth comes in two forms: capital appreciation and reinvested income (dividends and interest). In the past few years, some stock investors may have felt the only benefit to owning stocks was the dividends they received. However, in 2009, the 370 stocks in the S&P 500 that paid a dividend were up 27.7% on average versus a return of 82.4% for the stocks that did not pay a dividend.2 Similar disparities in returns were prevalent for international stocks as well, but that won’t always be the case. One global manager with 90 years of experience, Tweedy Browne, believes that higher-quality dividend paying stocks offer investors much better value today than non-dividend paying stocks.2 Owning stocks of the companies that are expected to provide the highest total returns over the long-run is the answer to achieving reasonable growth over time.
For bonds, one way to keep more of your investment return is to hold municipal bonds in taxable accounts and hold corporate bonds in tax-deferred accounts. Since interest from municipal bonds is normally tax-exempt (at the federal and sometimes state level), the 2011 and 2013 tax increases may make municipal bonds look more appealing to high income taxpayers. However, since historically bonds do not provide the level of capital appreciation of stocks, reallocating your portfolio away from stocks into tax-free municipal bonds isn’t favorable for the portion of the portfolio that is needed to provide long-term growth above inflation and taxes. Finally, investors with sizable unrealized capital gains that are looking to further diversify their portfolio should evaluate whether recognizing gains before January 1, 2011 is prudent, as the federal capital gain rate is going up in less than six months.
Where You Save Will Matter
A diversified investment strategy should include a variety of savings vehicles including taxable accounts, tax-deferred accounts and tax-free accounts (such as Roth IRAs or Health Savings Accounts). This provides flexibility in managing current and future cash flow and taxes. As earnings in 401(k) plans, IRAs and Roth IRAs are tax-deferred, and distributions will not be subject to the surtax beginning in 2013, maximum funding of these accounts could be a good decision. However, the amounts distributed out of these plans (excluding Roth IRAs) could push a taxpayer over the surtax threshold, thus causing their other investment income to be subject to the 3.8% surtax, while also driving up one’s marginal tax rate. The Healthcare Act simply strengthens the argument for not having all of your savings dollars in one basket. An effective long-term wealth accumulation strategy should incorporate a variety of financial tools and strategies to plan for future withdrawals at any age, given changing tax rates and economic conditions. A well-designed investment plan should not be overhauled simply to avoid taxes. However, minor modifications with a plan for the future may preserve more wealth for your family.
1 JP Morgan Market Insights, Guide to the Markets, March 31, 2010
2 Tweedy, Browne Company LLC, 4th Quarter 2009 Commentary
