With all the buzz around the fiscal cliff and the Bush tax cuts that are set to expire in 2013, what tends to get overlooked is a tax that will definitely take effect in the new year: the 3.8% tax on investment income.
Congress passed the 3.8% tax in 2010 to add an estimated $210 billion of funds into the Patient Protection and Affordable Care Act (PPACA) and Medicare overhaul, and the new tax is scheduled to go into effect on Jan. 1, 2013.
“We know this is meaningful, and it’s going to happen,” said Katie Nixon, chief investment officer in Northern Trust’s wealth management business, at a media briefing in New York.
(Click to enlarge Nixon’s chart, below, “New Medicare Related Taxes: Effective January 1, 2013,” for her 3.8% tax explanation.)
As a result, advisors are getting their clients ready now for the inevitable and helping them decide whether to sell any assets before the end of the year. The challenge is getting clients to take action now.
Indeed, the level of resistance to taking action can be seen in Nationwide Financial’s recent survey showing that most affluent investors have no plans to meet with their advisors to discuss tax code changes even though the vast majority, 88%, said they are confident in their advisor’s ability to help them prepare for those changes.
Best time to plan is now
“The 3.8% tax doesn’t relate to the fiscal cliff. It relates to Obamacare,” said Joseph Perry, a New York-based partner-in-charge of tax and services for Marcum LLP, an accounting and advisory firm.
“The key,” Perry added, “is for people to reach out now to their accountants and financial advisors to plan for the year-end to legally reduce the amount of taxes they would pay in order to put more money in their pocket. What we find at Marcum is that clients aren’t focused on the 3.8% tax. We’re recommending them to get their financial advisors involved and sometimes their attorneys.”
According to the congressional Health Care Caucus’ information site, the new tax will be imposed on unearned net investment income, including capital gains from stock sales, dividend income, bonds, mutual funds, annuities, loans and home sales. People subject to the tax are individual filers who earn adjustable gross income of more than $200,000 and married couples filing jointly with AGI of more than $250,000.
“In its simplest form, if you have a single person who receives $50,000 in interest income, that person will get taxed. The tax includes capital gains, but it doesn’t include salary, bonus, pension or IRA,” Perry said.
‘People are overreacting’
Rusty Vanneman, chief investment officer of CLS Investments, based in Omaha, Neb., said his firm has fielded “big questions” from worried financial advisors and brokers who work with individual investors.
“People are overreacting and talking about selling in 2012, thinking if they sell this year they don’t have to pay next year. Yes, that’s true, but if you sell now and take gains, you don’t have money working for you next year,” Vanneman noted. “Selling now is overly simplistic, but if you were going to sell something anyway, then you should do it this year instead of next. But you don’t have to rush and sell stock if you were planning to hold it a long time.”
Vanneman added that many money managers who typically reallocate assets in January will rebalance portfolios in December instead, and he predicted that there might be an overreaction in the selling of dividend stocks. In fact, he said, dividend stocks have outperformed the market since Obama’s re-election, and if there is a selloff, it could present a buying opportunity for savvy investors.
He pointed to a Nov. 7 Fidelity Viewpoint where Joanna Bewick, portfolio manager of Fidelity Strategic Funds, challenges the conventional wisdom suggesting that Obama’s win could create headwinds for dividend-paying equities.
“First,” Bewick writes, “about half of all assets that hold dividend-paying equities are already in tax-advantaged vehicles, so they’re indifferent to tax policy. Second, historical data around dividend-paying stocks’ performance when tax policies change is inconclusive: These assets have tended to outperform non-dividend-paying stocks, regardless of changes to dividend tax rates. This tells me that tax policy in a vacuum has only a slight influence over asset prices, compared with the overwhelming factors of the economic cycle and corporate profits.”
Looking at tax-sheltered alternatives
But Perry of Marcum LLP said that next year, his firm’s clients could see higher capital gains tax rates to as much as 39.6%. Adding the 3.8% tax would bring that total to 43.4%, more than double what they’re paying in taxes now.
“It’s definitely going to be more burdensome for people who are counting on dividend income,” Perry said. “High earners don’t understand the impact. I have one client, a very high net worth individual with a lot of investment interest, who may owe $1.3 million more. So we’re looking at tax-sheltered alternative investments such as municipal bonds, life insurance and tax-deferred annuities.”
Investors might also want to consider selling stock positions, paying the 2012 capital gains tax, and then repurchasing the stock in 2013, Perry said. “If you have stock that has greatly appreciated, it might make sense to sell the stock now in 2012 before you’re subject to the higher rate, and buy it back.”
In other words, say an investor bought a stock at $5 and it’s now at $50. On Dec. 28 of this year, the $45 profit would be subject to a 15% capital gains tax and no 3.8% surtax. Then on Jan. 2, the investor can buy the stock back at a cost basis of $50. So if the stock goes up to $60 and the investor decides to sell it, he or she is taxed on the difference between the cost basis and the gain, which is only $10.
Kent Kramer, wealth management partner with Schwab Impact award-winning RIA firm Foster Group of Des Moines, Iowa, is telling his clients that the capital gains tax might rise to 20% next year, and with the 3.8% added on top of the 20%, his clients are looking at a rate of 23.8%.
For a married couple with AGI of $250,000 who bought stock at $1,000 and sold it at $2,000, they would pay $238 in capital gains taxes in 2013 rather than $200 in 2012.
“We’re in a period where we’re telling our client to pay their capital gains now, at 15%, instead of what could go to 23.8% overnight,” Kramer said. “If you have a stock you’ve been thinking about selling, maybe now is a good time to sell it.”