Balancing Investments as Multiple Tax Hikes Loom
Life + Money

Balancing Investments as Multiple Tax Hikes Loom


Washington's fiscal cliff offers a tax hike for just about everyone to hate. If Democrats and Republicans can't strike a deal on an extension of the Bush-era tax cuts by the end of the year, tax rates on income, capital gains, dividends and estates all will jump.

A dividend tax hike could hurt some seniors, who report a substantial amount of dividend income on their tax returns. But for most seniors, there actually would be very little impact if rates do jump. Let's take a look at the numbers:

The Bush-era tax cuts, set to expire at the end of this year, reduced the maximum tax on qualified dividends and capital gains to 15 percent - and to zero for filers in the 10 percent and 15 percent tax brackets.

But if the cuts expire at year-end, the maximum rate on capital gains will be 20 percent; dividends would go back to being taxed as ordinary income, at Clinton-era rates. Filers in the highest bracket - 39.6 percent - would see a substantial jump in taxes on dividends; so would filers in the lowest brackets, whose rates would go from zero to 10 percent, or 15 percent.

Whether any of this comes to pass depends very much on the outcome of the November election. "If the Democrats do well in the election, you could see a compromise solution in the lame-duck session," says Mark Luscombe, principal federal tax analyst at CCH. "If the Republicans take full control of Congress and the White House, they may decide to wait until next year to enact what they really want."

A study of Internal Revenue Service filing data by the Edison Electric Institute makes the case that seniors would take the hardest fall off the cliff where dividends are concerned. Thirty-two percent of all tax returns reporting qualified dividends were filed by taxpayers age 65 and older; 68 percent were from returns with incomes less than $100,000, and 40 percent were from returns with incomes less than $50,000.

Other evidence suggests the damage among seniors would be limited. About 79 percent of senior filers had incomes under $75,000 last year, and this group reported just 5.5 percent of all capital gains and dividend income last year, according to a study by the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution.

Most reported dividend income was concentrated among households with incomes over $100,000 - just 13 percent of all over-65 filers.
So, what would happen if the preferential tax treatment for dividends and capital gains were eliminated? For the majority of seniors (60 percent), after-tax income would fall by less than one-tenth of one percent, on average.

Wealthier seniors would take a bigger hit. For example, filers with income from $500,000 to $1 million - a really small group - would see after-tax income fall 3 percent. Wealthy elders would pay not only the higher tax rates on dividends, but also the new 3.8 percent Medicare contribution tax on net investment income (interest, dividends, capital gains and rents) enacted to help pay for the Affordable Care Act. That tax affects individuals with modified adjusted gross income over $200,000, and married joint filers with MAGI over $250,000.

For wealthy investors looking to protect investment income, the political uncertainty makes it difficult to take proactive steps. One option would be to accelerate capital gains into this year. "Even if you wanted to keep a stock, you could sell it now and re-purchase it, since the wash-sale rule applies only to loss situations," says Luscombe. "But if the Republicans take control and reduce the rates beyond what we have now, you could look fairly foolish," he cautions.

Converting tax-sheltered IRA assets to a Roth IRA this year offers an effective insurance policy against the risk of higher tax rates next year or down the road, Luscombe notes. You'd owe income taxes on whatever amounts are converted this year at the current Bush-era rates, but the assets - along with any appreciation - would come out of the Roth tax-free in the future for you or your heirs.

Also, you'd have the opportunity to "re-characterize" the converted funds anytime until October 15th next year - meaning you could change your mind and reverse the conversion. You might want to do that if a tax deal to your liking materializes before then, or the value of your holdings falls after the conversion - leaving you with an income tax bill on evaporated holdings.

"If you made money, you keep the Roth," says IRA expert Ed Slott. "If not, you can reverse it, eliminating any taxes on value that no longer exists."

No matter what happens in Washington, investors should think strategically about asset location - maximizing after-tax returns by buying and holding stocks or bonds in either taxable or tax-deferred accounts, urges Maria Bruno, a senior investment analyst in Vanguard Investment's counseling and research group.

Vanguard suggests buying tax-efficient broad-market index equity funds or exchange-traded funds in taxable accounts; hold bonds, bond funds or dividend-oriented funds or shares in tax-sheltered accounts.
"You want to have different buckets of taxable and tax-advantaged accounts, and focus assets that are inefficient from a tax perspective in the tax-sheltered accounts," Bruno says.

There could be a buying opportunity for high-yield equities if the tax rates do jump next year, says Josh Peters, editor of Morningstar's Dividend Investor newsletter.

"If high net worth investors dump dividend stocks for tax reasons, it could be a good opportunity for investors in lower brackets who aren't affected by the tax changes to add to their holdings at lower valuations and higher yields," says Peters.