(By Christine Benz) A slew of Bush-era tax laws are set to expire at the end of 2012,
affecting the tax rates on everything from dividends to capital gains
to ordinary income and estates. But a lot remains unsettled, too,
particularly given that we're in the midst of an election year and the
direction of tax rates remains a key bone of contention.
Posting in the Portfolio Design/Management forum of Morningstar.com's Discuss boards,
I recently asked Morningstar.com readers whether they were taking
action with their portfolios to mitigate the threat of higher taxes down
the line. Readers were quick to share their strategies, with Roth
conversions, preemptive capital gains harvesting, and proper asset
location among the most frequently discussed tactics. But other readers
aren't so sure it's wise to act preemptively, given that the future of
tax rates might not be settled until later in the year.
'We Want to Be Ahead of the Crowd'
One strategy that received repeat mentions from Morningstar.com
users was the idea of selling highly appreciated securities in 2012, to
take advantage of today's relative low capital gains tax rates. Capital
gains rates are poised to go from 15% to 20% for most investors in
2013.
Outlining the strategy was JBP57, who wrote, "Come December
we will be selling and repurchasing all taxable accounts that have gains
to get the step-up in basis and pay the tax on the gains at this year's
tax rate."
Dragonpat will be starting to sell winners even earlier:
"Starting in October/November any stock or mutual fund that has a least a
20% gain on it, I am going to sell and possibly rebuy at a higher basis
to minimize future taxes."
Yet several posters warned that this strategy might not be the
slam-dunk it seems to be, particularly if sellers are rushing the exits
at the same time.
Big Red wrote, "I expect funds and individuals to harvest
gains and realize corresponding loses this year, putting significant
selling pressure on the markets resulting in falling prices starting
mid-October. We want to be ahead of the crowd, harvesting gains and
taking loses soon in the hope of repurchasing many of the same stocks at
an equal or lower cost basis in November and December. We are willing
to risk having to repurchase at higher prices because we do not intend
to withdraw any monies for 12-15 years."
Edmund_Dantes,
in fact, thinks that tax-loss selling could create buying opportunities
for opportunistic investors. "My principal consideration in this regard
is to be cognizant of tax-loss selling deadlines for institutions (Oct.
31) and the typical date when the bulk of individual selling ends (Dec.
15). I suspect institutions especially will be keen on realizing
taxable gains this year, at the lower rates. I suspect this to create
greater-than-normal selling pressure and am consciously keeping my cash
balances higher than normal--both to preserve capital and to participate
should a buying opportunity occur."
FidlStix is also licking his chops. "My 'financial fantasy'
right now is that everyone will jump in to sell taxable securities at
end of year to harvest gains/losses and pay taxes at present tax rates.
The resultant sell-off will make shares plunge to attractive prices.
Then I, the proverbial tiger crouching in the bushes, will pounce on as
many of those wounded shares as my stomach can hold. Dream on."
Bnorthrop, meanwhile, reckons that his tax losses might be
more valuable than ever in a high-tax regime; his goal is to save them
for when he really needs them. "All I'm doing is trying
to prolong my tax loss carryforward from 2008-09 by annual tax-loss
harvesting. The carryforward may be more valuable in the future."
Rule 72 says he's not inclined to sell preemptively, in part
because he already has a strategy for reducing the tax hit on his
portfolio's biggest gainers. "For the foreseeable future we may never
need the equity money in the taxable account and the kids would get the
stepped-up basis upon our death. Thus, no tax on that gain anyway."
'Focus on Known Bets'
For other posters, the planned tax increases provide yet
another reason to max out tax-advantaged vehicles and make sure they've
optimized their asset location for maximum tax efficiency.
JavaJoe is taking advantage of all the tax-sheltered options
he can think of and pulling money from taxable accounts. "As a young
accumulator, our approach has been to maximize tax-advantaged accounts
and focus on 'known bets.' In part because of upcoming tax law, but also
due to overall market valuations, we've tried to drain our taxable
investment account over the past few years by aggressively funding two
529s and two Roths, maxing out a SEP-IRA, contributing to a 401(k), and
then donating our most appreciated securities or tax lots in our taxable
account into a donor-advised fund for future charitable giving. And,
although controversial, we decided to take some proceeds from our
taxable account and 'lock in' the interest rate savings and tax
treatment by paying off our home mortgage."
Managing taxable portfolios to limit the tax collector's cut of ongoing returns was also the subject of discussion.
What to do with dividend payers, where the tax rate is set to jump
from 15% for most investors to the ordinary income rate, was top-of-mind
for Big Red. This poster shared a multipart strategy for
dealing with the threat. "We intend to concentrate our low-dividend
growth stocks in taxable accounts. This will allow us to manage our tax
liability over time by offsetting gains with corresponding losses
(assuming the tax code will still allow offsets). We also plan to move
dividend stocks into our IRAs and at least delay the impact of our
federal tax rate increasing from 15% to nearly 45% which will hurt more
than a little. Finally, we will probably increase our proportion of
tax-exempt muni-bonds. With state and local taxes on dividends a little
over 50%, some munis may be attractive even at these low rates."
Counterpoint is similarly concerned
about limiting taxes on his taxable portfolio, though he's cautious on
municipal bonds given their recent runup. "I already have a healthy
exposure to muni bonds and am concerned about overvaluation in this
sector. There are also grumblings that munis may not remain tax exempt
for upper income investors forever."
Instead, this investor has been tinkering with the equity portion of
his taxable account to make it more tax-efficient. "One change I started
making last year was building a portfolio of individual large cap
blue-chip stocks with low (less than 2.5% yield) or no dividend. First, I
view this subset of blue-chip stocks as generally being better valued
than higher-yielding blue chips. Second, these stocks will (hopefully)
have more of a capital gains and less of an income component so I can
minimize and better manage my future income recognition. Finally,
individual stocks will give me more flexibility in netting gains and
losses to reduce capital gains in the event I decide to liquidate some
equity positions in the future. For other equities, I remain
substantially invested in low turnover equity vehicles like
SPDR S&P 500 (SPY)
and avoiding, for the most part, funds that have a lot of turnover and
distribute a substantial amount of capital gains most years. One final
thing I may have mentioned before (sorry if I did) is investing in
Kinder Morgan Management(KMR),
one of the Kinder Morgan entities. This particular entity pays its
dividends as stock, and these stock dividends are not taxable until the
stock is sold. I wish there were many more investments like this."
Mr. Ed will also help his in-laws revisit their taxable
portfolio if in fact the dividend tax rate jumps up. "I will investigate
the possible effects of the changes on my in-laws' taxes. They are not
wealthy, and estate tax changes will not affect them. However, since
they are in 15% bracket, with significant dividends, it is time to talk
with their primary investment company about portfolio structure and
selling."
'I'll Just Have to Be Long-Lived to Make This Work'
Another frequently mentioned strategy was to convert
traditional IRA assets to Roth, which would have multiple potential
benefits in a higher-tax clime. First, the taxes due upon conversion
would be based on 2012's relatively low rates. Second, Roth assets will
be even more valuable if income tax rates rise in the future because
Roth withdrawals are tax-free. Finally, Roth assets aren't subject to
the new Medicare surtax going into effect in 2013.
Converting is top-of-mind for Dragonpat, who wrote, "I am
going to turn 59 1/2 in September. I am going to convert as much of my
401(k) to a Roth as I can with tax money that I am going to harvest out
of a stock option that I have saved for this purpose and some stock
from the employee stock purchase plan."
Jomil has been on top of this strategy for some time,
writing, "I converted [my] remaining traditional IRA shares to Roth in
2010 with the tax paid over two years. After retiring three years ago, I
rolled over various deferred compensation retirement accounts into
traditional and then Roth IRAs."
Chief K has been converting traditional IRA assets to Roth,
and will be doing some more this year, with the expectation that future
tax rates will be higher than they are today. "I'd considered not
making any more Roth conversions this year, especially since I'm 67 and
would have to count on a long life to make the conversion pay off.
However, I've concluded that our national debt will force us to accept
both higher tax rates as well as lower government spending. Hence, I
will be converting some of my company's Simple IRA Plan this year to my
Roth at Vanguard. I guess I'll just have to be long-lived to make this
work.
Many of Dragonpat's planned tax-related maneuvers aim to reduce her susceptibility to the new Medicare surtax.
She wrote, "I am going to discontinue Roth 401(k) contributions Dec.
31, 2012 and only make regular 401(k) contributions, to lower my
adjusted gross income to get as little of our income taxed by the new
3.8% Medicare tax." (The surtax kicks in on whichever amount is less:
net investment income or adjusted gross income over certain thresholds.)
Dragonpat went on, "Similarly I have been moving my mutual
funds to my Roth ($6,000) per year out of my taxable portfolio to avoid
the 3.8% Medicare tax on distributions. My taxable portfolio will be
100% exchange-traded funds and individual stock so that capital losses
and gains can be harvested more easily using limit orders."
Susanirs, like many savvy investors, has the estate tax on
her radar as 2012 winds down. On her extensive tax-related to-do list?
"Relook at our wills for estate planning since the [amount that skirts
estate tax] could be dropped to $1 million." Artsdoc agrees: "I am
definitely making an appointment with my estate attorney for December."
'I'm Not Changing a Darned Thing'
Yet even as some readers planned to be actively maneuvering in
the second half of the year, others said that they're standing pat.
ColonelDan is happy with his portfolio from a tax
standpoint; no further tinkering is needed. "No changes: IRAs will
remain as is and taxable side will stay in intermediate-term munis."
Similarly, DrBobb isn't putting the tax cart before the
horse. "I'm retired and I don't plan to make changes to our portfolio
based on possible tax law changes. It is impossible to predict how the
tax law might change. Much of our portfolio is in muni bonds and
dividend-paying stocks. The munis are not likely to be affected. And we
won't sell the stocks because we need the dividend income."
Vince5280, too, aims to stay focused on the investment merit
of his income-heavy portfolio rather than the tax implications of some
of its holdings. "I'm concerned about the tax changes, but I feel that
it is more prudent to continue focusing on the best long-term investment
versus the impact of taxes."
JHASheville also sees few reasons to begin tweaking."No
question about it. I'm staying put. I like where the portfolio is and
although I'm not fond of taxes a little more won't hurt when it comes
right down to it. Couldn't tweak it too much anyhow because the only
side that could us a snip here or there is in our taxable accounts and
no real losers to harvest from at this time."
Other posters noted that they weren't making preemptive portfolio
alterations, believing that Congress could make significant changes
before it's all over. Cliff offered an analogy that will
resonate with long-suffering fans of Chicago's National League ball
club. "I'm not changing a darned thing in advance of what may or may
not happen. Doing so, for me, would be about the equivalent of booking
airline and hotel reservations now to attend the celebration party when
the Cubs win the World Series this year. Things might not work out as
anticipated."
Skipperchg didn't mince words: "Anyone making major
portfolio changes on the basis of what Congress (particularly this one)
might or might not do with taxes is out of their minds."
Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success.