Investing in a rising tax environment

By Andrew H. Friedman
Download: Investing in a rising tax environment

One of the centerpieces of President-elect Obama’s campaign was his promise to reduce taxes paid by middle class families and provide new benefits to families in the lower classes. At the same time, he made clear his intention to pay for these new initiatives by increasing taxes imposed on families with taxable income over $250,000. The Democratic leadership in Congress has echoed this call for higher tax rates on the affluent.

Given this background, Congress in the coming session is likely to consider legislation to shift more of the tax burden from the middle class to affluent families. Hastening the need for such legislation is the fact that tax rates on upper income families are scheduled to rise automatically at the end of 2010, when the tax cuts initiated by the Bush Administration expire. If those rates are permitted to expire, the top tax rate on ordinary income will rise from 35% to 39.6%, the top tax rate on dividends will rise from 15% to 39.6%, the top capital gains rate will rise from 15% to 20%, and the estate tax exemption will drop from $3.5 million to $1 million per person. The Democrats have asserted that they will not extend these lower tax rates when they expire for the wealthy. So, whether by political action or inaction, tax rates on affluent taxpayers are likely to rise.

In addition, Congress must address the alternative minimum tax, which was aimed at affluent individuals but is affecting an ever growing number of middle class taxpayers. Elimination of that tax is estimated to cost the government one trillion dollars over ten years.¹ Congress is likely to recoup this lost revenue through new taxes on the upper-income individuals to whom the AMT was originally intended to apply.

Finally, additional tax revenues likely will be needed to finance mounting federal expenditures. The federal deficit was projected to grow significantly, even before incurring the additional costs of the 2008 economic stimulus legislation and financial crisis remediation. Social Security and Medicare outlays are projected to increase dramatically in coming years to meet the needs of aging baby boomers. The addition of a prescription drug benefit will increase the cost of Medicaid as well. Interest payable on the inflated national debt is projected to grow significantly. And the government is expected to spend significant sums to replenish armed forces and military equipment. Meeting these expenditures could require more taxes, the bulk of which likely would be borne by higher income families.

Now may be the time for investors to consider options to help blunt some of the effects of a potential tax increase. Some of these options are reviewed below. Investors should not necessarily undertake any or all of these steps now. In many cases, it will make sense to consider them as we learn more about the future course of tax legislation. In the meantime, investors should review these steps with their financial advisors, as well as their attorneys and tax advisors, and begin to discuss whether – and when – they could make sense in their particular circumstances.

Steps to consider in 2008 in anticipation of possible tax rate increases in future years

1. Sell assets in 2008 to take advantage of existing capital gains rates.

The current top rate on capital gains is 15%. If it appears the tax rate on capital gains may increase in 2009, it could be worthwhile to sell assets in 2008 to take advantage of the low current rate. A recent study determined that, if asset values increase by 8% per year and the capital gains rate increases from 15% to 20%, an investor will have to hold assets for at least an additional five years to be better off than had he sold the assets initially and paid tax at the lower rate.²

A special opportunity exists for taxpayers who can keep their 2008 income low. Beginning in 2008 (and scheduled through 2010), married taxpayers with taxable income below approximately $65,000 ($32,500 for single taxpayers) pay no tax on dividends received or capital gains recognized. Dividends received and capital gain recognized count toward this $65,000 income limitation.

Taxpayers who can reduce their taxable income may be able to sell some assets in 2008 without tax. For instance, suppose a married retiree couple avoids taking income in 2008 from their investments, pension, and other retirement assets. Assume they pay $20,000 in deductible mortgage interest. This couple will be able to recognize about $85,000 in capital gain and dividends in 2008 without tax (because their total taxable income after recognition of this gain will be around $65,000).

The zero percent capital gains rate provides retirees, and perhaps other taxpayers, with an efficient opportunity to reposition investments from growth to income-producing assets to generate future retirement income. Other taxpayers as well can reposition assets at a cost of a 15% tax on gain.

2. Receive ordinary income in 2008 rather than in a later year when tax rates may be higher

The current top rate on ordinary income is 35%. If ordinary income rates are expected to rise in 2009, investors could seek to receive additional taxable income in 2008 rather than in later years. For instance, executives could consider exercising some non-qualified stock options in 2008, when the resulting income will be taxed at prevailing rates.

3. Defer discretionary deductible payments (such as charitable contributions) to later years when they may be worth more due to higher tax rates.

The tax benefit of a tax deductible expenditure increases as tax rates increase. If a tax rate increase is expected, it may be worthwhile to defer deductible payments until the higher rate takes effect.

For instance, at the top federal tax rate in 2008, a charitable contribution of $100 yields a benefit of $35. If the federal rate rises to 40% in 2009, making that contribution next year will save $40 in taxes.

Steps to consider after a tax rate increase

1. Give increased consideration to municipal bond investments.

As tax rates increase, the effective interest rate on municipal bonds similarly increases. For instance, a municipal bond paying 3% interest pays a tax-equivalent yield of 4.6% in a 35% tax rate environment. But if tax rates rise to 40%, the tax-equivalent yield on the same bond rises to 5%. Thus, investing in municipal bonds and municipal bond funds may make sense in a rising tax environment.

2. Give increased attention to buy-and-hold investment strategies.

As the tax rate on capital gains increases, the tax deferral afforded by buy-and-hold strategies becomes more valuable. Thus, it could be worthwhile to hold investments longer to defer the higher taxes due upon sale.

3. Be prepared to shift from dividend-paying stocks to growth stocks if the tax rate on dividends later rises disproportionally.

Currently dividends are taxed at the same rate as capital gains (15%). Initiated as part of the Bush tax cuts, this lower tax rate on dividends is an anomaly in U.S. tax law. Historically dividend income, like interest income, has been taxed at the same rate as ordinary income (currently 35%). Some lawmakers believe that a low dividend tax rate is ill-advised, and the lower tax rate on dividends could come under scrutiny.

Currently, however, the prevailing view seems to want to maintain a dividend tax rate equal to the capital gains rate (although both rates may rise in tandem). If, contrary to current expectations, the tax on dividends rises above the tax on capital gains, then investors at that time may wish to consider moving assets from dividend-paying stocks to growth stocks.

4. Consider tax-efficient mutual funds and other professionally managed tax-advantaged investment strategies.

A rise in tax rates can meaningfully reduce the net returns provided by tax-inefficient investments. In a rising tax environment, a tax management strategy that seeks to enhance after-tax return by balancing investment and tax considerations becomes increasingly more important.

Tax management techniques include purchasing stocks with a long-term perspective to delay recognition of taxable gain, reducing turnover to minimize short-term gain, investing in stocks that pay qualifying dividends, harvesting tax losses, and selectively using tax-advantaged hedging techniques as an alternative to taxable sales.

Similarly, investment strategies that manage or defer taxes, such as exchange funds, provide increasingly greater benefits as tax rates rise.

5. Consider investing in annuities and life insurance that offer tax deferral.

Life insurance provides tax deferral and a tax-efficient way to pass wealth to future generations. Earnings underlying a life insurance policy accumulate without current tax. If the policy is held until death, the death benefit is not subject to income tax. These tax savings increase if tax rates increase.

Today, many investors are turning to variable annuities to provide tax deferral, guaranteed lifetime income, the potential of equity upside, and a death benefit for heirs they name as beneficiaries. The owner of a variable annuity invests assets in a choice of investment options offered by the annuity issuer. Earnings on those assets accumulate tax-deferred until distributed. When withdrawn, income is taxed at ordinary rates (and if taken prior to age 59-1/2 may incur a tax penalty). The owner can choose to receive payments from the annuity guaranteed for life.³

Depending on the contract terms, for an additional fee a contract owner may irrevocably elect an optional guaranteed minimum withdrawal or income benefit rider. A “guaranteed minimum withdrawal benefit” (GMWB) provides a safety net for retirement assets – no matter how those assets perform – by guaranteeing that the contract owner can withdraw annually for his lifetime an amount (typically 5% to 7%) of no less than his original investment (provided he does not withdraw more than the guaranteed amount in any year). If this benefit is elected, an increase in the value or the underlying assets will result in a higher annual payment (5% to 7% of the higher number). But this annual payment will never go down, even if the asset value later declines or the contract owner lives longer than expected. Thus, in essence, the holder receives a guaranteed annual payment based on the “high water mark” of the underlying asset value, as computed under the terms of the annuity contract.³

When the owner of an annuity contract dies, the assets remaining – and perhaps more if the contract owner for an additional fee has elected a guaranteed minimum death benefit rider – are paid to his designated beneficiaries. (Unlike death benefits paid by life insurance, annuity death benefits are subject to income tax, although a beneficiary can choose to defer that tax by “stretching” the payment of the annuity death benefit over his life.) In a rising tax environment, the tax deferral feature of annuities becomes increasingly valuable.

6. Be prepared to convert a traditional IRA to a Roth IRA in 2010.

Roth IRAs give investors the opportunity to realize future investment earnings tax-free. Particularly in an era of rising tax rates, this feature can provide significant value.

Currently, only families with adjusted gross income under $100,000 are permitted to convert a traditional IRA to a Roth IRA. Beginning in 2010, however, all individuals are eligible to make this conversion. Taxpayers who expect to be taxed at the same or a higher rate in future retirement years should consider this option seriously.

If assets have been held in a Roth IRA for at least five years and the account holder is at least age 59‑1/2 (or has died or become disabled), then all Roth withdrawals – including withdrawal of earnings – are received entirely tax-free.⁴ Moreover, while assets held in a traditional IRA must begin to be distributed when the holder turns age 70‑1/2, no such distribution rules during life apply to a Roth IRA. Rather, a Roth IRA holder may choose to maintain assets in the Roth, where they can continue to accumulate tax-free.

Post-death distribution rules do apply to a Roth IRA in the same manner as to traditional IRAs. Thus, at death the Roth balance must be distributed to a named beneficiary within five years or over the beneficiary’s lifetime. (Spousal beneficiaries are exempt from this requirement and may continue their deceased spouse’s Roth IRA intact.) All distributions made to the beneficiary from the Roth retain their tax-free character, so that the beneficiary, like the original Roth holder, receives the Roth assets entirely tax-free.

When the holder of a traditional IRA converts to a Roth, he recognizes taxable income on the previously untaxed value of the converted IRA in the year of conversion. If the conversion occurs in 2010, however, the holder may pay this tax half in 2011 and half in 2012. Amounts converted after 2010 are subject to tax fully in the year of conversion. The holder may choose to convert all of his traditional IRA to a Roth in a single year, or to convert only a portion and decide when to convert additional portions in later years.

The holder typically pays the conversion tax with non-IRA funds. (If he uses IRA funds, amounts withdrawn to pay this tax are subject to income tax and may also be subject to a 10% penalty.) Paying this tax with outside funds in effect provides an additional contribution to the Roth IRA, as the assets in the IRA account remain the same, but now all future taxes on those assets have been paid.

Choosing the proper investment for a Roth IRA can enhance its value. For instance, many holders are purchasing variable annuities in their IRAs to prepare for the conversion in 2010. As discussed above, variable annuities with optional income benefits can provide guaranteed lifetime income that increases as investment assets increase but does not decline if asset values go down (provided no excess withdrawals are taken). Where the annuity is held in a Roth, this guaranteed income stream is entirely tax-free. Moreover, when the Roth IRA holder dies, the annuity death benefit is available to the IRA beneficiary, who may “stretch” the payment of that benefit and receive payments over his lifetime. Those lifetime payments to the beneficiary – like the payments to the original Roth investor – are tax-free. Thus, a variable annuity purchased with Roth IRA funds can provide tax-free income to two generations.

Andrew H. Friedman is a former senior partner in a Washington, D.C. law firm. He speaks regularly on legislative and regulatory developments and trends affecting investment, insurance and retirement products.