From the February 2009 issue of Wealth Manager Web • Subscribe!

Tax Planning in the New Administration

More On Tax Planning

from The Advisor's Professional Library
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There's lots of uncertainty about who will be helped and who will be hurt by the tax package that President Barack Obama will send to a Democratic-controlled House and Senate. Still, there is no doubt that he wants them to approve tax code amendments requiring wealthier Americans to shell out more for taxes.

Which existing breaks deserve to be continued and for how much longer, and what new ones ought to be introduced and how speedily should they go on the books are as much political questions as economic ones. All that is clear is that lots of debate and political horse-trading will lead to important changes. Look for intensive negotiations on which revisions should become effective prospectively and which retroactively and just how to word hundreds of amendments. Some revisions will be phased in, becoming effective over several years.

Whatever the course, your clients will have many questions which you might want to answer in meetings, seminars or newsletters. To help prepare you to meet their demands, in the next two issues of Wealth Manager we'll look at the prospects for individual earned income and estate taxes, with a detour around the rocky terrain of the Alternative Minimum Tax. What follows are highlights of the new administration's major proposals for investment income and how they could benefit or adversely affect clients at various income levels.

The Rate Game

On the campaign trail, candidate Obama proposed increases from 15% to 20% to the top rates for long-term capital gains on stocks, bonds and most other assets and qualified dividends for individuals in the two top tax brackets--adjusted to affect only individuals with incomes over $200,000 and families with incomes above $250,000. (At press time, it was still unclear whether $200,000/$250,000 refers to wages, gross income, AGI or taxable income.) And clearly, President Obama's position is that the top rate for dividends should continue to be far less than the top rate for ordinary income. Therefore, investors in the 10% and 15% brackets would still be taxed at a rate of 0% on long-term capital gains and dividends.

While on the hustings, President Obama said nothing about revising the current top rate of 28% for long-term gains from sales of collectibles and art. But he indicated his support for elimination of all capital gains taxes on investments in small and start-up companies, although this proposal's details have not been spelled out.

Unlike his rival, Sen. John McCain, who called for substantially increasing the dollar limits on deductions for capital losses, Obama was silent on changing the loss limits which have not been revised upward since they went on the books in 1978. Current law allows investors to offset losses against capital gains and as much as $3,000 of ordinary income from sources like salaries and pensions. (The ceiling drops to $1,500 for married couples filing separate returns.) Unused losses over $3,000 may be carried forward. So amid the thorns, there is an occasional rose: Losses--including those from 2008 and earlier--will become more valuable if the top rates for long-term gains and ordinary income go up. For instance, if we assume the top income tax bracket goes from 35% to 39.6%, the tax saved by a $3,000 deduction rises from $1,050 to $1,188.

Tax Rates for Dividends

In addition to reducing the tax rates for ordinary income, the Bush legislation dramatically dropped tax rates for dividends for all investors--to less than half the top rate for ordinary income. Previously, the rates for dividends matched the rates for wages and other types of ordinary income. The current rules tax dividends from corporations and mutual funds at a top rate of 15% percent for someone in the four top brackets and 0%--down from 5% before 2008--for the two bottom brackets. The revisions did not reduce the rates for interest, which is taxed as ordinary income.

But all dividends are not equal. The current 15% or 0% rates apply only to "qualifying" dividends, while dividends that fail to pass the qualification tests are taxed at ordinary income rates. For example, there are no reduced rates for dividends from stock purchased with borrowed funds when the dividends are included in investment income. This mirrors the pre-2003 rule that long-term capital gains must be taxed as ordinary income if they are treated as investment income.

Another limitation targets short-term and day-traders. Investors must own stock for at least 61 days for it to qualify. Otherwise, any dividends received are taxed as ordinary income. Moreover, the 61 days must occur during a 121-day holding period that starts 60 days before the stock's ex-dividend date.

Again, the reduction for dividends is not permanent. Unless Congress extends the 2003 revisions, in 2011 and subsequent years, dividends will again be taxed at ordinary-income rates (which may go as high as 39.6%).

Long-term Capital Gains

President Bush and congress decided to decrease the top rate for long-term capital gains from sales of assets such as individual stocks, bonds and shares of mutual funds owned more than 12 months. The rates dropped from 20% to 15% for individuals in the four highest income tax brackets and from 10% to 0% (was 5% before 2008) for those in the two lowest brackets. But the reductions did not apply to all assets. The maximum rate for long-term gains from sales of art, antiques, coins and other so-called collectibles stayed at 28%--nearly double the top rate for securities.

They also left unchanged a maximum rate of 25% for long-term gains from sales of real estate attributable to depreciation. The 25% rate affects individuals who invest directly in commercial properties, including apartment buildings and motels, and indirectly through REITS. Once the 25 % rate on captured depreciation is met, the 15% rate applies.

Short-term gains from assets owned less than 12 months are taxed at ordinary income rates, currently as high as 35%. Someone in the 35% bracket (2009 taxable income above $372,950) who sells shares for a $10,000 profit owes $3,500 for a short-term profit that would shrink to $1,500 for a long-term profit. But unless congress extends them or makes them permanent, these rates, too, will "sunset" in 2010 and revert to 20% and 10% in 2011, as they were before the 2003 legislation.

Interest Income

The rates that start at 10% and go as high as 35% for ordinary income continue to apply to interest received from government bonds and "dividends" (considered interest) paid on savings accounts, CDs and other savings vehicles. Similarly, neither the reduced rates for dividends nor those for long-term capital gains apply to withdrawals, whether voluntary or required, from traditional IRAs, 401(k)s, annuities and other tax-deferred retirement plans; instead, ordinary income rates apply. No wonder some investors might perceive that as a disincentive to moving more money into retirement accounts.

Fundamentals of Good Tax Planning

Tough economic times require the White House and both Houses of Congress to cut deals on tax rates for ordinary income, capital gains and dividends. Whatever happens to taxes, many time-honored techniques will still work well for most people. Among them is a standard admonition to maximize deferral possibilities. Whenever possible, clients should avail themselves of traditional IRAs and other tax-deferred retirement plans to hold taxable bond funds, REITS or high-turnover stock funds that incur short-term gains. And they should use taxable accounts to hold shares of mutual funds that generate long-term gains and dividends--assuming dividends continue to be taxed at the rates for long-term gains. That noted, it is still necessary to run the numbers. Moving too much money into tax-deferred plans can cause investors to get hit with more overall taxes when they take money out. And this is where wealth managers can be indispensable. Your clients' decisions on which investments are best held inside or outside such plans must jibe with their individual risk tolerance and investment aspirations.

Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books can be found at

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