Gliding Off the Fiscal Cliff: Financial Planning for the Road Ahead
For the past decade, investors have enjoyed the dual benefit of low taxes on both dividends and capital gains. As part of the Bush-era tax cuts that were passed in 2003 and extended in 2010, the tax on long-term capital gains (assets held for at least one year) was capped at 15% for investors in the four highest tax brackets, which would include anyone who has more than $35,350 in taxable income this year. Even better, investors in the two lowest tax brackets were completely exempt from capital gains taxes. In addition, qualified dividends received the same preferential tax rates as capital gains.
Such tax rates were a welcome benefit for investors who have suffered through a decade of low stock returns, but the approach of the “fiscal cliff,” Washington’s latest self-imposed crisis du jour, will likely increase these investment tax rates, especially for wealthier individuals who make more than $250,000 per year.
Assuming that nothing is done to reach the long-awaited “grand bargain” on various tax increases and spending cuts, capital gains and dividend taxes will automatically increase in 2013. The top tax rate on capital gains will revert to 20%, while qualified dividends will be taxed as ordinary income, which means that investors in the top tax bracket could pay as much as 39.6% on their dividend income. (Remember income tax rates will increase next year, too!)
As bad as this sounds, it is even worse for those with high incomes because these tax increases don’t account for the additional 3.8% Medicare tax on all unearned income, including capital gains and dividends, that will be imposed next year as part of Obamacare for families with a modified adjusted gross income of more than $250,000 per year. When added together, the wealthiest investors could potentially lose nearly one-quarter of their capital gains and close to half of their dividends in taxes.
Things are far murkier when it comes to the vast majority of investors who do not have a six-figure income. Politicians from both parties have repeatedly emphasized the importance of maintaining the current tax rates for middle-class families, so it is fairly safe to assume that, at a minimum, income tax rates will remain the same for them. However, this is far from guaranteed, especially given that this assumption depends on a bipartisan agreement between Democrats and Republicans, which has become an increasingly rare phenomenon in recent years.
There is considerable uncertainty with respect to future tax rates on investment income, which makes the financial planning road ahead difficult. Although middle-class families may be able to avoid the worst of these tax increases, they should give everyone an appreciation for the ephemeral quality of tax rates on investment income.
However, regardless of the ultimate resolution to this crisis, there is one action that might make sense for many investors who are currently in the 0% capital gains tax bracket: selling. Investors in this tax bracket can be certain that capital gains taxes will never get any lower, so by selling and immediately repurchasing an appreciated asset, its cost basis will be reset to the higher price. As such, if capital gain tax rates are increased in the future, the amount of profit on which that tax will be calculated will be reduced when you sell the asset for good.
One of the best ways to avoid this mess, both now and in the future, is to contribute as much as you can to your tax-deferred and tax-free savings accounts. Whether you invest in a company-sponsored 401(k) or an IRA, all the money in these accounts is protected from capital gains and dividend taxes. With Roth accounts, you will also be able to protect yourself from the risks associated with future tax increases on income tax rates.
Even if you max out contributions to your 401(k) and IRA, you may have additional ways to protect your investment income from the deleterious consequences of capital gains and dividend taxation. Some government workers may have access to a 457 plan, which can be used in conjunction with a 401(k) plan, to increase your total yearly contributions. In addition, if you have your own business, you could potentially have access to retirement plans like a solo 401(k) and SEP-IRA.
If you have no room to make additional contributions to your tax-advantaged retirement accounts, you can always invest your money in a taxable account. In this case, you could consider buying tax-managed mutual funds or index funds, both of which have low annual turnover, which helps to keep capital gains distributions to a minimum.
Whatever you do, make sure to consult a qualified tax professional to help you navigate the muddy waters of taxes before making any rash decisions, especially given the approaching fiscal cliff. You should also avoid allowing the tail to wag the dog. Although it is important to take advantage of all available tax breaks, don’t let your financial plan get hijacked by matters over which you have little control. Instead, focus on the things you can control, like your savings rate and asset allocation, and leave the convoluted tax debates to the politicians in Washington.
