The Tax Compromise and Your Portfolio

Jason Stipp: I'm Jason Stipp for Morningstar.

Now that the big tax compromise has cleared both chambers of Congress, we're finally getting some clarity on all that tax uncertainty we've been dealing with in 2010. But now that the details are sharpening, what does the picture look like for your portfolio?

Here with me to offer some ideas is Morningstar's Christine Benz, Director of Personal Finance. Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So this bill does a lot of things that are on the way, and I just want to talk to you about some of the details and some ideas that you have based on those for your own portfolio.

The first one, which I think was kind of a surprise to see in the compromise is lowering of the Social Security tax that's taken out of your paychecks. What are the details on that and what's your idea regarding that?

Benz: So the Social Security Tax that people will pay will go from 6.2% to 4.2%, and the idea there is to put more money in people's pockets, get them out their spending. But the idea that I would have is for someone who doesn't need that money, if you don't need it to spend on day-to-day bills, what you should do is if you're not fully funding your 401(k) up to the limit, you should think about steering part of that tax break you're getting into a higher 401(k) allocation.

Kind of a side benefit, Jason, you really brought up this idea, so I owe you credit for it – but, if people are concerned that the Social Security plan is underfunded long-term and concerned that this tax break will put additional pressure on it, all the more reason to make sure that your own retirement plan is as funded as it possibly can be. So try to get that 401(k) allocation up to the maximum possible.

Stipp: So you would be normally seeing a little bit more money in your paycheck because of this. So if you go ahead and just put that in the 401(k), you might not notice any difference from this year, so maybe a painless way to go ahead and do that.

Benz: Right, you wouldn't even see the money.

Stipp: Sure. So the other thing I think, and this was the one that most people who had been paying attention to, are those taxes on the dividends and the capital gains. So what's the story there with the compromise, and what does that mean for how you should now be able to plan a little bit better?

Benz: Essentially we're seeing the same capital gains and dividend tax rates that were in place before stay in place. So one strategy we had been hearing a lot about, thinking that capital gains and dividend tax rates were going to shoot higher, you're were hearing people say, well, if you have companies in which you have long-term gains, better to get rid of them now at today's lower tax rates than sell them later on. Don't do that. Now, the name of the game will be to defer those capital gains as far into the future as you possibly can.

Stipp: Now the dividend tax rate, in the Bush era, it was lowered. So I think that made dividends a lot more attractive to a lot of folks. With the dividend payers in your portfolio now, I think, people think of these as very low rates on dividends. So does that mean that you should always put your dividend payers in your taxable portfolio because of the tax advantages or what's your take on that?

Benz: Well, I would say in general, you're right, that the dividend tax rates are nice and low, but I do think that it shouldn't be a given that you want to hold these in your taxable accounts. So the reason is that, when you have any company that's paying you a dividend, you are ceding a level of control. So, you are taking a payout on which you will owe taxes, when you don't necessarily have to.

So, ideally you would own growth companies in your taxable accounts that are not going to be paying you dividends. Of course, that's a little bit different if you are in retirement and you need to take those required minimum distributions from your accounts anyway, its fine if they are dividends, but for people still in accumulation phase, probably don't want a lot of dividend payers in your taxable accounts.

Stipp: Another thing in the tax compromise has to do with your income taxes. Those will be staying the same. What's the implication on the portfolio level from that part of the legislation?

Benz: Well, I think one of the key ones, Jason, is that this idea of converting a Roth in 2010 would enable you to split the tax hit associated with that conversion over two years, 2011 and 2012. Up until the time that we had clarity on what tax rates were doing, people were really wondering well, is this a good idea, am I better off just taking the tax hit now paying at today's low rates versus possibly having to pay at higher rates down the line. Right now, I think splitting that tax hit looks like an awfully good strategy, because tax rates are going to stay the same. \

But of course it's a very individual, specific situation. So, if for whatever reason you think your own personal income is going to be lower and push you into a lower tax bracket in 2010, and you have the money right now to pay taxes associated with the conversion, you may as well get it done this year because your own personal tax rate will be lower.

Stipp: Final thing we got some clarity about is the estate tax, and we talked about in several videos this year how the uncertainty about the estate tax was really throwing a wrench in the planning works. What clarity do we have on that now, and what are the implications for your plans on that front?

Benz: So, under the new tax package, estates over $5 million are taxable, and they are taxable at a 35% rate. So, this is pretty good for people who do not have very large estates. That means that you won't owe estate tax and even if you do, you won't owe a lot, you won't owe that 55% that had been bandied about. So, that's a plus.

I would say, though, to people who might say, "well now I can back burner all things estate planning," don't do that, because there are still a lot of things that fall under the category of an estate plan that have nothing to do with your total nest egg.

So, everyone needs a will, everyone needs a living will, and importantly everyone needs to designate some of these agents to carry out their estate. So, if you become disabled, you want to have that medical power of attorney, want to have that financial or durable power of attorney, and certainly if you have minor children, you want to have your guardians designated. You don't want anyone else making those important decisions for you.

Stipp: Christine thanks so much for breaking down the legislation and for offering the tips today.

Benz: Thank you Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.