What the New Tax Package Means for Investors

Question: A lot of the media concentrated on the political wrangling that went on behind the scenes to enact the new tax laws. But what are the implications for regular investors?

Answer: You're right--there was a lot of political back and forth leading up to President Obama's signing of the tax bill last week, and the new tax laws have coincided with the busy holiday season. Given all that, it's no wonder many investors haven't been keeping close track of the details.

Here's a brief overview of what to keep on your radar regarding taxes in the months ahead as well as some concrete strategies to help you benefit from the new packet of laws.

Income Tax Rates
With the expiration of the Bush-era tax cuts, income tax rates were set to go up starting in 2011. But after much wrangling in Congress, tax rates are staying the same.

The strategy: Given the status quo on taxes, making a Roth conversion in 2010 is looking like a really good deal. That's because for 2010 and 2010 alone, those who convert a traditional IRA to a Roth will be able to split the tax hit over two years, 2011 and 2012. This maneuver wasn't a slam-dunk prior to the passage of the tax package because those who split the tax bill over 2011 and 2012 may have ended up paying taxes at higher rates than if they had just bitten the bullet and paid it all at once. But now that we know tax rates will be staying the same, converting now and deferring the taxes looks smart indeed.

Social Security
The new tax package cuts the Social Security tax from 6.2% to 4.2% for 2011, giving an effective boost in pay to all workers. (As in the past, you won't pay Social Security tax on any earnings over a certain level--currently $106,800.)

The strategy: The Social Security tax cut is designed to put dollars in consumers' pockets and get them out there spending. But if you can afford to do so (and importantly, you have the self-control to stay away from the mall), a better idea is to divert that money to another retirement fund: your own. Bump up your 401(k) plan contribution as close as you can to the annual limit; in 2011, that limit remains $16,500 for those under 50 and $22,000 to those over 50. And if you're already funding your 401(k), 403(b), or 457 plan to the max--or if you would rather save outside the confines of your company plan--you can direct that money to an IRA instead.

Dividends and Capital Gains Tax Rates
Under the new tax laws, dividend and capital gains tax treatment will stay the same in 2011 as in 2010--a 15% maximum for dividends as well as a 15% rate for long-term capital gains. Given that the capital gains tax rate was poised to jump up to 20% and dividends were set to be taxed at an investor's ordinary income tax rate, investors dodged a bullet on this one.

The strategy: First, what not to do: While some prognosticators had suggested that investors pick through their portfolios for long-held winners to sell at 2010's low tax rates, that sort of preemptive selling is no longer necessary. Instead, the name of the game is to defer the realization of capital gains until you absolutely need to sell a security for investment-related reasons and/or you're certain that tax rates will be going up. The longer you can put off paying taxes on your investment earnings, the more your winnings can compound and increase on your behalf.

The fact that dividend tax rates will be staying nice and low also means that dividend-paying stocks aren't definitely off-limits for taxable accounts. However, it's worth noting that dividend payers are generally less tax-efficient than nondividend payers. That's because dividend payers make taxable payouts whether you want them or not, so you're ceding a level of control over taxes. By holding nondividend payers in your taxable accounts, by contrast, you won't be on the hook for taxes unless you take action and sell shares.

Alternative Minimum Tax
For tax years 2010 and 2011, Congress put in place a so-called patch to keep a new group of taxpayers from having to pay the alternative minimum tax, a parallel tax system that disallows many of the credits and deductions that taxpayers are entitled to under the conventional tax system.

The strategy: The latest AMT patch is good news. But if you've fallen into the AMT zone in the past, the latest patch isn't likely to keep you out of it.

However, by taking steps to control your AMT-subject income and managing your deductions, you may be able to reduce your AMT tax hit. This article discusses some of the key strategies you can employ, including carefully managing the exercise of stock options (a well-versed tax advisor should be able to help with this) and watching out for private-activity municipal bond funds, which aren't taxable under the conventional tax system but are for the purposes of AMT.

Estate Tax
For all but the wealthiest individuals, the tax package brings good news on the estate-tax front. Yes, there is an estate tax in 2011 (unlike 2010), but it only affects those who die with estates worth more than $5 million. Moreover, the estate tax rate will be relatively low in 2011 and 2012, just 35%.

The strategy: Even if you don't anticipate that you'll ever amass $5 million in assets, there's more to creating an estate plan than sidestepping taxes. A properly crafted estate plan will detail how you'd like your assets distributed after you're gone and will also specify agents to act on your behalf if you should become disabled. This article outlines some key aspects of estate planning that apply in all tax environments.

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