Saturday, February 16, 2013

Tax Report: The New Capital-Gains Maze


 Laura Saunders for the Wall St. Journal writes: Chances are your capital-gains taxes are going up this year—and if you aren't careful, you could end up paying more than necessary. Amid the political drama surrounding the "fiscal cliff" negotiations, some investors overlooked significant tax changes kicking in this year. Most notable: those on long-term capital gains, or taxable income from the sale of investments held longer than a year.
Under the old system, there were often only two rates: zero and 15%, depending on your income. Now, there are three tax tiers: zero, 15% and 20%.  And that isn't all. There also are three backdoor tax increases that can push your effective rate even higher—to nearly 25%.
Experts say many taxpayers whose rate still is 15% could well owe one-third more than they would have last year. And many top-bracket taxpayers will owe nearly two-thirds more, even if their income is that high only because of a once-in-a-lifetime sale.
"These are significant increases, and they raise the value of tax deferral and careful planning," says Vanguard Group tax expert Joel Dickson.
Investors who have begun to consider these issues—and many haven't—admit to being confused.
"I'm trying to figure out whether it's even worth it to have a taxable account," says Matt Reiland, a 32-year-old oil-industry financial analyst in Farmington, N.M., who now is putting away $1,000 a month.
Fortunately for investors, there still are ways to minimize the hit—and even dodge it. Strategies include carefully timing investment sales, making charitable donations and family gifts with assets instead of cash, and minimizing certain income. With markets approaching record highs, investors need to know them.
To be sure, long-term capital gains still retain many of the advantages investors have cherished for decades.
Unlike wages, capital gains often can be timed. Losses on one investment can be "harvested" and used to offset gains on other investments, even in different years. Up to $3,000 of capital losses still are deductible against "ordinary" income such as wages. And whatever an investor's top rate on gains, it often is far below the rate on ordinary income, which now can be more than 41%.
It isn't just capital gains that are affected by the tax changes. The new provisions also apply to many dividends, and some apply to other investment income, including interest. But these types of income often are more difficult to time than long-term gains.
Where You Stand
This year's changes divide taxpayers into three groups. For joint filers with more than $450,000 of taxable income or single filers with more than $400,000, the tax rate on long-term gains is fairly clear, if painful.
It starts with a flat tax of 20% above those thresholds. Add to that the new "Pease limit," a complex backdoor increase tied to itemized deductions that is named after Donald Pease, a former Ohio congressman. In effect, the Pease limit raises a taxpayer's rate by about 1%, according to experts at the Tax Policy Center, a nonpartisan research group in Washington.
Finally, there is a new 3.8% flat tax on net investment income—unless the investor has sold an actively managed business—for a total of about 25%.
Thus, for a taxpayer already in the top bracket, the tax on a $500,000 gain could rise to about $125,000 this year from $75,000 in 2012.
For taxpayers in the next income tier—couples with $72,500 to $450,000 of taxable income and single filers with $36,250 to $400,000—the effective rate on a gain is harder to predict.
It begins with a 15% flat rate, but taxpayers who cross certain income thresholds owe more because of the 3.8% net investment income tax, the Pease limit and the Personal Exemption Phaseout, or PEP, a backdoor increase that limits personal exemptions.
Here's how it could play out: Say a couple with two children in college and a third soon to go has an adjusted gross income of $220,000. They sell long-held investments to help pay tuition, realizing a $175,000 gain. Although they are in the 15% bracket for long-term gains, just as they were in 2012, they'll owe about $5,500 more than they would have last year due to the new 3.8% tax.
This is where planning can help. If the couple can lower their income by, say, raising retirement-plan contributions or spreading the gain over several years, or both, they might reduce or avoid the extra taxes.
"If they cut this year's gain to $50,000, the $5,500 would drop about $750," says Roberton Williams, a tax specialist at the Tax Policy Center.
The last group are investors who owe zero tax on their long-term gains. They often avoid the 3.8% tax, the Pease limit and the Personal Exemption Phaseout as well.
For couples filing jointly, the zero rate extends up to $72,500 ($36,250 for singles). That might sound like a low cutoff, says Silicon Valley tax strategist Stewart Karlinsky, an emeritus professor at San Jose State University, "but it includes more people than we used to think."
That's because these investors often have large amounts of tax-free income, thanks to municipal bonds or Roth individual retirement accounts. If so, they might be able to realize gains selectively to stay within the zero rate.
Sound complicated? It is—and the alternative minimum tax can make it worse. But careful planning is often worth the effort. Here is what to do to minimize your gains pain this year.
Lower your adjusted gross income. An especially confusing feature of the new capital-gains regime is that while rates are tied to taxable income, for most taxpayers the backdoor increases are tied to adjusted gross income.
That's the number at the bottom of the front page of the 1040. It doesn't include itemized deductions on Schedule A, such as mortgage interest and charitable gifts. Taxable income does.
To avoid the backdoor taxes, it is important to minimize your adjusted gross income. Itemized deductions won't help, but other tax benefits can. Among them: deductible contributions to retirement plans such as IRAs or 401(k)s; moving expenses; business deductions or losses; capital losses; rental-property expenses; alimony payments; and health insurance premiums or health-savings-account contributions, according to Mr. Karlinsky.
Tax-free income from municipal bonds or Roth IRAs won't swell adjusted gross income, either. Converting to a Roth IRA will, however, raise it in the year of the conversion.
Take advantage of "air pockets." The tax code stacks income, deductions and net long-term gains in a way that shrewd taxpayers can exploit.
Here's an example: A retired couple has $70,000 of adjusted gross income before capital gains and $30,000 of itemized deductions. (They might also have tax-free income from munis and Roth IRAs.) According to tax rules, the deductions reduce their income to about $40,000.
This leaves them with an "air pocket" of about $33,000 before they cross from the zero rate to the 15% rate on long-term gains.
If they take a $50,000 gain, nearly $33,000 of it won't be taxable, while the rest would be taxed at 15%. If their income remains constant for two years and they can split the gain between the two years (selling at the end of December and beginning of January, for example), the entire gain could be tax-free.
This is a great tax-code freebie. "People in the zero bracket can even harvest gains and raise their cost basis without owing federal taxes," says Mitch Marsden, a planner at Longview Financial Advisors in Huntsville, Ala. Unlike with assets sold at a loss, there's no waiting period to repurchase assets sold at a gain.
Of course, the value of multiyear strategies depends in part on Congress not changing the law again.
Give appreciated assets to charity. Higher taxes raise the value of making charitable donations with appreciated assets such as shares of stock instead of cash. Under current law and within certain limits, the donor gets to skip the tax and yet take a near-full deduction for the gift.
Strategize family gifts. Are you thinking of giving cash to relatives or friends in the same year that you plan to sell a long-held asset? If your recipient is in a lower capital-gains bracket, consider giving him all or part of the asset instead. Taxpayers can give presents of up to $14,000 per individual per year free of gift tax, and the move can save on capital-gains tax as well.
For example, say a woman wants to give $14,000 to her granddaughter, who is between jobs. If she gives $14,000 of stock shares she bought for $3,000, the granddaughter could sell the shares and pay no tax if her taxable income is below $36,250 this year. But if the grandmother sells the shares herself, the tax bite could range from $1,650 to more than $2,500.
Hold on for dear life. The tax code still forgives capital gains on assets held until death; at that point the asset's full market value becomes part of the taxpayer's estate. Now that the estate-tax exemption is a generous $5.25 million per individual (and indexed for inflation), some investors will find it makes sense to hold appreciated assets until death in order to avoid higher capital-gains taxes.
Consider installment sales. Assets such as land or a business can be hard to sell piecemeal. But an owner could sell the entire asset in an installment sale and spread out a gain over several years, assuming the deal makes overall sense.
Remember the home exemption. Couples who sell a principal residence after living in it at least two years get to skip paying tax on up to $500,000 of gains ($250,000 for singles); only above that does the gain become part of income.
Beware of lower limits for trusts. The new 3.8% tax on capital-gains and other investment income takes effect at $11,950 of adjusted gross income for trusts—far lower than the $250,000 threshold for individuals.
But there is an out: The lower limit applies to income that's retained by the trust, while income that's paid out to beneficiaries is taxed at their own rates.
"This puts pressure on trustees to make distributions," says Diana Zeydel, an estate lawyer at Greenberg Traurig in Miami. Yet the point of some trusts is to retain gains and accumulate assets, or at least to keep the beneficiary on a short tether. These issues require expert help.
Don't be driven by taxes. Don't sell—or hold—an asset just to beat Uncle Sam. Don't do an installment sale if you can't trust the buyer to pay up. And don't make charitable or personal gifts solely for tax reasons.
But if you are going to realize a gain, do pause and plan. Especially for large sales, consider using a tax professional. The Tax Policy Center has a good online tool for making before-and-after estimations at calculator.taxpolicycenter.org.
And keep in mind that the new complexity is daunting even for the pros. Says Donald Zidik, a tax specialist at accounting firm McGladrey in Boston: "We simply can't do back-of-the-envelope estimations anymore."

Posted on 7:18 AM | Categories:

Retirement Account Withdrawal Tax Rates


Michael Flannelly for Dividend.com writes: Taxes are a sensitive subject in Washington; whatever tax rates the policymakers set ultimately affects investors, corporations, and individuals on Wall Street and Main Street alike. When preparing for retirement, individuals must take into consideration these potential tax rates and what they will be when they withdraw from their retirement accounts down the road. Planning for the future is an effective step in staying ahead of the curve on the path towards retirement. But to get the most bang out of your retirement account’s bucks, paying attention to the potential tax rates of retirement account withdrawals is an absolute must.
One of the common questions regarding IRAs and 401(k)s from account holders is what will the tax rate be when you actually begin your withdrawals at retirement age (usually stated to be 59.5 years old). The answer to this question varies depending on the different retirement accounts and various stipulations and rules that cause the rates to vary. To get the most up to date information regarding your retirement account distribution tax rates and how it will affect your retirement income, consult with your financial advisor or tax professional.

Tax Rates of Withdrawn Funds

For the most part, the withdrawn funds taken from Traditional IRA are taxed as normal income at the time you withdraw. The benefit in these accounts is that the contributions made to the IRA are either from pretax income or tax-deductible income. 401(k) retirement plans have its withdrawn funds taxed as normal income as well.
In a Roth IRA the withdrawn distributions are 100% tax free as long as your are between the ages of 59.5 and 70.5. The difference with a Roth IRA is that the contributions are made after-tax. If you expect to have a high income tax rate during your retirement, then a Roth IRA is probably the best option to avoid paying the taxman a substantial portion of your income in retirement. For more on the differences between Traditional and Roth IRAs, check out the Dividend.com IRA Guide.
The good thing about these retirement accounts is that holdings are tax deferred – meaning the capital gains and dividends earned from investments in the accounts are not taxed until you ultimately withdraw the money in retirement. At that point these funds are taxed as normal income if in a Traditional IRA or 401(k) as stated above, which can be a rate from 10% to 39.6% depending on your income. [Check out how dividend stocks and Roth IRAs can work as an exceptional retirement strategy.]
After you retire, your income, and thus your income-tax rate, is likely to be lower than it was when you were working. This factor should be taken into consideration when determining what retirement account plan is best for you. While retirement plans that allow for tax-deductible contributions seem appealing in the short-term, long run factors into retirement can result in saving more from potential taxes if you opt for a retirement plan with tax-free distributions. But everyone has a unique situation, so shaping your plan for how it suits you best is necessary.

Nest-Egg Withdrawal Rule of Thumb

Figuring out a budget for everyday living expenses in your golden years can be a tough task. Now that you have some idea of how taxes may affect your retirement account withdrawals you may be wondering how much you should actually need during retirement.
Traditionally, the rule of thumb was that you should withdraw 4% of your overall nest egg from your retirement accounts each year, and your money should last as long as you do. However, this is assuming that your assets continue to grow at that same rate (or preferably more) to support your future income stream. As is the case when it comes to investments, this rate of return can fluctuate year to year, especially in volatile markets and a struggling economy.
As such, you need to check up on your finances every year to stay up to date on your current situation. Consulting with a financial planner may help determine how much exactly you need and should withdrawal each year.

The Bottom Line

Putting together an effective retirement strategy that takes into consideration the nuances of contributions and the tax rates of withdrawn funds can result in significantly more money in your pocket when you reach your golden years. These various retirement accounts are a good way to add to your sources of income during retirement in addition to other savings, investments, pensions, and even Social Security. Assessing your potential income and income tax-rates can result in the best bang for your buck on the road to retirement.
Posted on 7:11 AM | Categories:

How Higher Tax Rates Could Affect Investors - T. Rowe Price


T. Rowe Price writes: The American Taxpayer Relief Act of 2012, the compromise bill passed on January 1 to deal primarily with tax aspects of the fiscal cliff, provided investors an element of certainty heading into 2013. The tax changes were permanent and mostly affected those in upper income levels:
  • The American Taxpayer Relief Act: Increases the maximum tax rate on dividends and long-term capital gains from 15% to 20% for those with taxable income above $400,000 for single filers and $450,000 for those filing jointly, and the top income tax rate for income above these levels increases from 35% to 39.6%.

    These income thresholds include dividends, interest, and capital gains and other income in addition to earned income.
Medicare surtax under the 2010 Affordable Care Act, known as "Obamacare," also goes into effect this year:
  • The 2010 Affordable Care Act levies a new 3.8% surtax on high earners who have "net investment income," which includes dividends and capital gains as well as bond interest. The tax is imposed on the lesser of the total net investment income or the amount of modified adjusted gross income (MAGI) in excess of the income threshold—$250,000 for married couples filing jointly or $200,000 for single taxpayers.

    For example, assume a single investor has $270,000 total MAGI in 2013, of which $45,000 is "net investment income." The investor must pay a 3.8% surtax on the lesser of $70,000 (the amount over $200,000), or $45,000. In this case, the tax applies to the $45,000, totaling $1,710 (i.e., 3.8% x $45,000).
How T. Rowe Price Investment Professionals View Taxes
While some high-income investors may want to review their taxable versus tax-exempt investment strategies and retirement programs, the higher tax rates should not be cause for fundamental changes to their long-term investment plans. The following analysis and insights reflects the views of our economic and investment professionals as of February 13, 2013.
Investments That Help Minimize Taxes
High-income investors affected by the rise in the top income tax rates and the 3.8% Medicare surtax might consider strategies that could help minimize their impact, though an investor's fund selection should be guided primarily by long-term goals and risk tolerance more than tax considerations.
  • Municipal bond funds, which provide income exempt from federal taxes and in some cases state taxes as well, could be even more appealing now. For an investor in the new 39.6% tax bracket, a muni bond fund yielding 4% equates to a taxable bond yield of about 6.6%, well above comparable Treasury yields. If the investor were also subject to the new 3.8% surtax, the taxable equivalent yield would be about 7%. However, future tax reform could include restrictions on tax-free municipal bond income for those in higher tax brackets.

    Taxes are always a big part of what drives interest in the municipal market, and with increased tax rates and no change in the municipal tax exemption, fixed income professionals expect to see continued strong demand from investors for tax-free muni bonds.

    Some municipal bond fund income may be subject to state and local taxes and the federal alternative minimum tax. Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative.
  • Tax-efficient equity mutual funds offer another potential opportunity to reduce greater tax exposure, because these funds are managed to minimize capital gain and dividend distributions to shareholders. Similarly, index funds, due to their passive management, tend to have relatively low turnover, which typically means minimal taxable capital gain distributions.

    These securities are subject to market risk, and share prices may be more volatile than those of slower-growing or cyclical companies.
Tax Implications for Equity Investors
While some analysts warn that equity prices, and particularly relatively riskier assets such as small-cap stocks, may be pressured by the boost in the capital gains rate, the past three decades of market history suggest that tax rate changes have had relatively modest effects on equity valuations and dividend policies. Moreover, investors should not focus on any short-term effects on the markets. In the long run, stock prices are more driven by such fundamental factors as earnings, interest rates, and economic growth than tax changes.
  • Historically, the overall impact of tax rate changes on equity returns and valuations appears to be modest. This observation is based on eight changes in the top tax rate on dividends (including the pre-2003 changes when dividends were taxed at the same rate as ordinary income) and four changes to the top long-term capital gains rate since 1980.

    In fact, the S&P 500 Index soared 27.7% in the 12 months following the 1990 increase in the maximum dividend tax rate (from 28% to 31%) and it gained 5.3% in the 12 months after the 1993 dividend hike (from 31% to 39.6%), according to market research firm Strategas Research Partners. Of course, past performance cannot guarantee future results.
  • It is inherently difficult to measure the impact of tax rate changes as markets react to many different factors, such as the 1990s technology bubble and the recovery from the 2000–2002 and 2007–2009 bear markets. Indeed, the capital gains rate in August 1981 was reduced from 28% to 20%, yet the S&P 500 declined 14% in the following six months amid double-digit interest rates and a double-dip recession.
  • Higher tax rates could be somewhat negative for the stock market for a period of time, but the hike in the capital gains rate is not expected to disproportionately disadvantage small-cap stocks.
  • Small- and large-cap stocks should be relatively unaffected as long as dividends and capital gains continue to be taxed at the same rate. When dividends were taxed at a higher rate than capital gains, small-caps were relatively advantaged; in some respects, that was the golden age for small-caps.
Do Tax Rate Changes Favor Non-dividend Stocks?
With dividends and long-term capital gains continuing to be taxed at the same rate, there is no inherent tax advantage, for example, in favoring growth-oriented stocks over those that provide relatively high or growing dividends. Still, higher tax rates could cause some companies to revise their dividend policies, affecting payout ratios and yield, according to investment  professionals.
  • For dividend stocks, economic environment is more critical than tax rates. In a slower growth world, like today, there's a case for dividend-oriented stocks to hold their own because they tend to be defensive, and the dividend portion of your return is more assured than capital gains.
  • Dividend-paying stocks typically do less well when the economic environment is stronger and risk taking is more prevalent—none of which is evident today. Investors should not abandon their long-term investment strategies in reaction to slightly higher rates. In addition to offering relatively attractive yields, companies with the ability to grow dividends over time tend to be high-quality companies with strong cash flow and relatively predictable earnings. Dividend stocks can provide a growing stream of income to hedge against inflation.
  • Tax-exempt and tax-deferred investors may reduce the market impact. Standard & Poor's estimates that up to two-thirds of dividends from S&P 500 companies—and as much as half of all other U.S. equity dividends—are paid to tax-exempt investors (such as public and private pension plans), tax-deferred investors (401(k) plans and individual retirement accounts), or foreign nontaxable investors. Such investors tend to be less sensitive to tax rate changes. To the extent that tax-exempt or tax-deferred investors are driving the market, tax rate changes should have minor impact on valuations.
  • The new 20% rate on the margin should have only a modest negative impact, and not necessarily for those companies that have a long history of growing dividends that have lived through various tax policies. If the dividend tax rate had reverted to ordinary income tax rates, with a top rate of 39.6% along with a lower capital gains rate, that could have significantly affected dividend policies of some companies.
  • Over the longer term, tax rates do appear to have influenced corporate dividend decisions. However, analysts say these effects appear to be extremely gradual, as companies are reluctant to cut dividends because that typically is viewed negatively by the market.
How Should Bond Investors View Tax Hikes?
The higher tax rates and prospective spending cuts and debt ceiling outcome could have a greater impact on fixed income:
  • The markets dodged a bullet, but uncertainty remains. Credit markets were expected to be more volatile than they've been. In the third quarter of 2011, debt ceiling discussions were not good for the markets.

    Then, yield spreads widened across credit sectors and a broad, global sell-off across risk assets occurred. Ironically, the U.S. Treasury market rallied after the U.S. credit downgrade following that debt ceiling fight as investors fled to perceived safety. Investors should not expect Treasuries to rally again if that history is repeated.

    The 10-year Treasury was yielding about 3%, and that flight to safety brought them down to 2%, where they've stayed. Today, there is a lot less room for Treasury rates to go down. But if negotiations become contentious and it looks like no deal will get done, rates could go down a little more. Treasury rates did go up this month on the fiscal cliff relief rally.
  • High yield bonds could suffer if the higher tax rates and potential spending cuts slow the economy more than expected. The market is pricing in perfection, so there is not a lot of margin for error and there is more risk to the downside if we get further progress on fiscal policy.
  • Munis are supported by strong demand from individual investors, particularly those subject to higher tax rates and the new 3.8% Medicare surtax. Municipals continue to offer attractive taxable equivalent yields, especially for those facing a maximum income tax rate now of about 43%, as opposed to 35% before. Although absolute muni yields may look low, new tax rates make them more competitive with other markets.
Posted on 7:07 AM | Categories: