BOSTON – This year's tax-filing deadline is a couple months away, and many investors are beginning to review whether they made any rash moves with their portfolios to trigger potentially unnecessary tax bills. It's a good instinct to follow, because it can become a teachable moment on how to become a tax-savvy investor.
But it's perhaps more important now to be mindful of new tax law changes approved in the deal that lawmakers struck in January to avoid the "fiscal cliff."
Those changes could have a big impact on taxes filed in 2014 and beyond, especially for those in the top income bracket. They'll pay higher rates, and will want to invest with a heightened sense of tax implications starting this year.
The rate increases are intended to help the U.S. get its fiscal house in order, but the medicine isn't entirely bitter. Historically low rates remain intact for investors in middle-income brackets, and the worst-case scenario rate hikes that were on the table during congressional negotiations failed to become law.
Another plus: The high uncertainty over taxes in recent years is largely gone. President Obama and congressional leaders continue to discuss raising revenue by capping or limiting some tax exemptions. But the rate levels in the Jan. 1 agreement to avert the fiscal cliff are expected to remain in place for the foreseeable future. There's no sunset date on the rates, unlike the Bush-era tax cuts approved in 2003.
"The most important thing is to have a plan, and now you can plan," says Duncan W. Richardson, chief equity investment officer with Eaton Vance, an investment manager whose specialties include tax-efficient investing.
Tax-savvy investors keep in mind the type of account in which they hold their investments. Only withdrawals are taxed from IRAs and 401(k)s, so these tax-advantaged accounts are good places to keep investments that are likely to generate a tax bill. Taxable accounts are the place to hold municipal bonds and mutual funds that invest in munis, because the income they generate is exempt from federal taxes.
Here are 4 other considerations for investing in the new tax landscape:
1. TAXES ARE HIGHER, BUT STILL MODEST HISTORICALLY
In the year ahead, investors should focus on their tax rates for capital gains and dividends.
In the middle-income tax brackets – those with adjusted gross income of $72,501 to $223,050 for married couples filing jointly, and $36,251 to $183,250 for single filers – the rate remains 15 percent on long-term capital gains. Those are the profits from selling such investments as stocks or funds held for at least a year.
The 15 percent on long-term gains is the same rate that applies to income from stock dividends. But the rate for capital gains and dividends has climbed to 18.8 percent for joint filers with more than $250,000 in income and $200,000 for single filers. That factors in a new 3.8 percent investment income surtax to help pay for President Obama's health care overhaul.
The biggest hit will be felt by top-bracket investors – those with adjusted gross income of more than $450,000 for couples, and $400,000 for individuals. They now pay 23.8 percent on long-term gains and dividends, including the health care tax. They will pay nearly 9 cents more in taxes than they did last year on each dollar of dividend income flowing into a taxable account.
Despite that increase, these rates are modest historically. In the 1970s, the top rate on dividend income was 70 percent, for example.
2. SHORT-TERM GAINS, BIG TAX BITE
The distinction between a long-term capital gain and a short-term gain remains important for investors in the top brackets, because tax rates continue to be far higher for the latter.
Short-term gains are triggered by profits earned from a taxable investment held less than a year. They're taxed as ordinary income, like wages, and high earners now face higher income tax rates. Those in the top bracket now pay a steep 43.4 percent including the health care tax, up from 35 percent. That's nearly 20 cents on the dollar greater than what they pay on long-term gains.
3. MUNI BOND ADVANTAGE GROWS
The rate also rises to 43.4 percent for income that top earners receive from taxable bonds, such as corporate bonds. As a result, those investors can realize a greater tax advantage than they could previously from investing in municipal bonds and muni funds, rather than in taxable bonds.
Investors don't have to pay federal taxes on income from munis, which invest in local and state government bonds. Munis are also free of state taxes if they limit investments to the state where you live. So consider whether munis' tax advantages will offset the higher pretax returns you'd normally expect from investing in a taxable bond fund. Look at tax-equivalent yield. It tells how big of a return you'd need from a taxable investment to equal the return of a tax-free bond.
4. BACKLOG OF TAXABLE GAINS BUILDING UP
Stocks have more than doubled since the market hit bottom in early 2009. That huge gain means there's a growing likelihood that investors will be hit with tax bills from capital gains. When fund managers sell investments that appreciated in value, they pass on the taxable gains to investors each year. Managers have been able to limit their investors' tax exposure in recent years by using losses incurred during the stock market meltdown of 2008 to offset gains. But that's no longer so easy, now that stocks have made such a sustained climb.
Tax exposure is typically greater at funds that trade holdings frequently. It's an especially important consideration for wealthy investors, now that they're paying higher rates. One option is to choose funds with moderate to low portfolio turnover. A fund with a turnover ratio higher than 50 percent – meaning more than half the holdings changed hands in a year – could be one to avoid.
If you're investing in an actively managed fund, consider those using strategies to limit capital gains – they often call themselves "tax-managed" funds.
It's not easy to sort out all the options on your own, so it might be worthwhile to seek professional help from a financial adviser.
Questions? E-mail investorinsight@)ap.org