From the July 2010 issue of Research Magazine • Subscribe!

July 1, 2010

Policy Analytics: Investing in a Rising Tax Environment

A former senior partner at Covington & Burling discusses investment options in light of an increasing tax burden.

A year and a half into the Obama administration, the federal budget deficit is soaring. Spending has swelled as the government expended funds to support financial institutions, stimulate the economy and provide benefits to out-of-work families. Meanwhile, the recession brought a precipitous drop in federal tax revenues.

To address the mounting deficit, President Obama has asked Congress to approve a tax increase on affluent families. The president is proposing permitting the Bush tax cuts to expire on schedule at the end of 2010, but only for families with taxable income over $250,000 (individuals with income over $200,000). Under this plan, the top tax rate on ordinary income will rise from 35 percent to 39.6 percent, the top capital gains rate will rise from 15 percent to 20 percent, and the top tax rate on dividends will rise from 15 percent to 20 percent.

Some members of the House Ways and Means Committee have indicated that the dividend tax rate should rise all the way back up to 39.6 percent, taxing dividends as ordinary income as they were during the Clinton years.

This year, Congress enacted a sweeping national health care program, the largest social program in decades. To finance the program, Congress approved an additional 0.9 percent tax on employment compensation in excess of $250,000 ($200,000 in the case of individual taxpayers) and an additional 3.8 percent tax on taxable investment income earned by families with adjusted gross income above $250,000 ($200,000 in the case of individual taxpayers).

The new taxes under health care reform are scheduled to take effect at the beginning of 2013, raising the top tax rate on ordinary income at that time to almost 44 percent and the top tax rate on capital gains to almost 24 percent -- an increase in the ordinary income tax rate of almost 25 percent, and in the capital gains tax rate of almost 60 percent.

Furthermore, it is likely that additional tax revenues will be needed to finance mounting federal expenditures. The deficit was projected to grow significantly, even before incurring the additional costs of economic stimulus, financial crisis remediation, and health care reform. Social Security and Medicare outlays are projected to increase dramatically in coming years to meet the needs of aging baby boomers. Interest payable on the inflated national debt also is projected to grow significantly. Meeting these expenditures could require more new taxes, the bulk of which likely would be borne by higher-income families.

By taking action this year, investors may be able to blunt some of the effects of future tax increases. Some options to do so 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.

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

Investors with long term gains in their assets should consider selling and recognizing the gain before the top applicable tax rate rises from 15 percent to 20 percent. Selling before a tax hike locks in gain and can produce a greater after-tax yield. For instance, consider an investor who purchased stock in late 2008 at $5,000 per share. Suppose that stock is now worth $15,000. If the investor sells in 2010 at a 15 percent capital gains rate, the sale will yield $13,500 after tax. To yield the same amount after a 20 percent tax rate, the stock value would have to increase to $15,625, an additional increase of over 15 percent.

Investors likely will be able to obtain the lower capital gains tax rate by selling at any time this year. But they should keep an eye on the tax bill as it moves through Congress, as Congress conceivably could move up the effective date to avoid a year-end sell-off. If that were to happen, investors likely would have sufficient notice to sell assets traded on an established exchange. But they might not have time to sell non-marketable assets such as real estate or a business. Investors selling those types of assets might want to consider a sale earlier in the year rather than later.

By selling this year, investors can lock in gains realized during the run-up that occurred in 2009. They then can redeploy the proceeds to investments that offer stable growth and downside protection, a strategy that might be prudent in uncertain times. One such investment is a variable annuity, which offers tax deferral as well as downside protection -- another important benefit as tax rates rise. Other investors who wish to keep their investments can sell a security, recognize the gain and immediately repurchase that security to reestablish the position.

The "wash sale" rule, which requires investors to wait thirty days before repurchase, applies only to recognition of losses, not gains.

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

With ordinary income rates expected to rise, investors might act to receive additional taxable income currently rather than in later years. For instance, executives could consider exercising non-qualified stock options this year so that the resulting income would 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 deductible expenditure increases as tax rates increase. With a tax increase expected, it may be worthwhile to defer deductible payments until the higher rate takes effect. For instance, at the current top federal tax rate, a charitable contribution of $100 yields a benefit of $35. If the federal rate rises to 40 percent, making that contribution next year would save $40 in taxes.

Thus, investors considering making large charitable contributions might consider deferring them until the beginning of 2011.

4. Give increased consideration to municipal bond investments.

As tax rates increase, demand for municipal bonds increases, because more people wish to reduce the tax they pay. Similarly, as tax rates rise, the effective interest rate on municipal bonds increases. For instance, a municipal bond paying 3 percent interest pays a tax-equivalent yield of 4.6 percent in a 35 percent tax rate environment. But if tax rates rise to 40 percent, the tax-equivalent yield on the same bond rises to 5 percent. In short, all other things being equal, rising tax rates can signal rising municipal bond values.

At the same time, the supply of tax-exempt municipal bonds is shrinking, as more states issue Build American Bonds (BABs), authorized by last year's stimulus legislation. BABs pay a higher rate of interest that is taxable to the holder. (For this reason, BABs can be particularly good investments for IRAs.) Increased demand coupled with reduced supply could have a favorable effect on the tax-exempt municipal bond market.

5. Give increased attention to harvesting losses and 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. Similarly, it becomes more important to harvest tax losses to shelter gains that otherwise would be taxed at the higher rate.

6. 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. Thus, a management strategy that seeks to enhance after-tax return by balancing investment and tax considerations becomes increasingly important in a rising tax environment.

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.

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

Life insurance provides tax deferral on un-withdrawn increases in cash value during life and a tax-efficient way to pass wealth to future generations. If the policy is held until death, the death benefit is not subject to income tax. If the purchase is properly structured, the death benefit may also be free from estate tax. These tax savings increase as 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. 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.

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 variable annuity with this rider provides a guaranteed lifetime income stream computed as a percentage of the "high water mark" of the underlying investments, as determined under the terms of the annuity contract.

When the owner of an annuity contract dies, the remaining assets -- and perhaps more if the contract owner has elected a guaranteed minimum death benefit rider (for an additional fee) -- are paid to his designated beneficiaries. An enhanced annuity death benefit may be particularly useful for an individual who cannot purchase life insurance for health reasons. 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.

8. Convert a traditional IRA to a Roth IRA.

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.

Beginning in 2010 all individuals are eligible to convert their traditional IRA to a Roth IRA.

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. 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, so they can continue to accumulate tax-free.

Post-death distribution rules apply to a Roth IRA in the same manner as to a traditional IRA. 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 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 at the rates in effect in those years, or pay the full tax in 2010 at 2010 rates. Given the proposed tax rate increase scheduled to take effect in 2011, the latter option may make more sense. Taxpayers in higher tax brackets who expect to stay in those brackets during retirement should consider this option seriously, as their tax rates are likely to rise in the future.

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. He may be reached through his website, TheWashingtonUpdate.com. The author is not providing legal or tax advice as to the matters discussed herein, which are general in nature and provided for informational purposes only. There is no guarantee as to accuracy or completeness. This discussion is not intended as legal or tax advice and individuals may not rely upon it as such.

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