Higher Investment Taxes on the Horizon

Jason Stipp: I'm Jason Stipp for Morningstar.

At the start of a new year, investors turn their attention to the often-dreaded task of filing their taxes.

Joining me today is Greg Rosica--he is a tax partner at Ernst & Young and contributing author to the Ernst & Young Tax Guide for 2012--to offer some tips about what should be on your radar screen and how you can take some of the stress out of tax-filing tasks?

Thanks for joining me, Greg.

Greg Rosica: Thanks for having me. Pleasure to be here.

Stipp: The first question for you: I think, from an investor's standpoint among the biggest changes that we could see next year is the possible expiration of the Bush-era tax cuts at the end of 2012. If those tax cuts expire, what does that mean, what does it reset to?

Rosica: So really where we are is, it's not an if at this point; they will expire. Based on the existing law that we have, at the end of 2012 those tax cuts we've enjoyed since the early 2000s do expire.

And what happens at that point, pending any other legislation, would be that the tax rates go back up to the pre-2000 era levels, which is, top rates of 39.6% for ordinary income, capital gains rates going back up, as well, from 15% back up to 20%. And then, in addition to that, we have other provisions that are in the law as well that will affect investors, such as the 3.8% surtax for the health insurance bill that was passed a year or so ago--that gets added on to those rates as well. So, you can see some very high tax rates that are in the law scheduled to take place January 1, 2013, unless some other legislation intervenes prior to that.

Stipp: So given that right now, it is a certainty, unless, as you mentioned, there is some intervention ... what kinds of questions should investors be asking themselves as they are looking at the portfolio in light of the fact that unless something happens, we will see these higher tax rates?

Rosica: You really need to look at your portfolio from the investment and the soundness of the investments that you have primarily, and not let the tax situation drive that.

But having said that, the difference between selling something at the end of 2012 and the beginning of 2013, may be a couple days or a month or two months difference, could be a significant decrease to your portfolio if the tax rates do in fact go up.

So I think examining it as we get closer to the situation and determining what the right investment move is for you and then overlaying what the tax consequences will be--maybe in two different scenarios, meaning at the end of 2012 versus the beginning of 2013, what that net-net might look like.

If you are a longer-term investor, and you are not going to be selling something early in 2013 or even until 2014, then you really need to look at that difference in the tax rates and the impact on that vis-à-vis what the investment performance might be and the present value of that money as well.

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Stipp: Greg, do you think that there could potentially be any implications for the types of accounts that you would hold certain investments in, given that we would see higher taxes, for example, on dividends. Would those potentially be a candidate, then, for a tax-deferred account if you had had them in a taxable account before?

Rosica: Sure. Certainly, as you indicated, all assets that come out of a tax-deferred account, so IRAs and the like, do come out with the highest ordinary tax bracket that you are in. So you don't enjoy things like capital gain rates or lower qualified dividend rates, if you utilize those levers for your investment.

So certainly, asset location becomes very critical as people looks through it. And in addition to that, you're really making sure that you maximize the tax brackets that you have available to you. So by that, I mean, oftentimes folks that are looking towards retirement may look to try to defer taxes as long as possible, but sometimes people do that and aren't actually taking advantage of the 15% bracket, really filling up that bracket, which really stays there with the married couple until around $70,000.

So, making sure that you're taking enough taxable income to take advantage of the lower tax brackets no matter what overall tax situation we're in, and we making sure you structure things. It might make sense to keep some assets outside a retirement vehicle that might cause you some current tax, but up to a certain controlled amount, a certain controlled tax bracket.

Stipp: Greg, you mentioned earlier that this expiration of the tax cuts is a certainty unless there is some intervening legislation. I think it's impossible for anyone to really handicap what might happen in Washington. One thing we do know, at least recently, is that Congressmen have waited until the last possible minute to make extensions and changes in legislation. Given the fact that we really don't know for sure whether there would be any legislation or not, but there is a possibility that these tax cuts could be extended, what would you recommend for an investor who is trying to plan around an event that has such uncertainty?

Rosica: I think, trying to wait as long as possible, because I think as we get closer to the end of the year, certainly there's no reason now to be pulling the trigger and locking in 15% capital gains today, while we still do have the rest of the year.

Now again, legislation could occur throughout the year that would change that, but certainly monitoring that and really using diversification in the tax strategies as much as you use diversification for your investments--meaning, you don't need to do all of one thing, you can do some of things.

So you might start to look at the assets that might make sense to start to turn over, maybe sell those and enjoy the lower rates, but things that are more longer-term, hold, there is no reason to really take an action too soon before we get some better indication.

We're obviously in the election year. Taxes are going to be a big part of all the platforms that are going to go through, and so, we are trying to see what's going to happen, and whether anything will be able to get passed up through the election process is going to be interesting to watch. But a good chance that nothing is going to happen until then, and then we're going to be into the beginning of 2013, with perhaps new legislation pending that has to be get implemented perhaps by a new candidate as well.

Stipp: Greg, let's turn and speak a little bit about something we do know more about, which is the 2011 tax year. Can you tell us some of the major changes or differences that should be on investors' radars as they fill out their taxes for the 2011 year?

Rosica: Well, the good news is, when we talk about uncertainty, there is a lot certainty in that, we know where things are today. So, we are not sitting here at the end of the year, the last week or beginning of the New Year, wondering what's going to happen tax-wise. There's nothing pending. There's nothing we're sitting on the edge of our chair waiting to find out. So, we do have certainty we know what's there today, and what's there for the 2011 tax year.

And really, one of those things is that there's not a whole lot of changes. So, the difference between 2011 and 2012 isn't really significant. Very minor things that have changed. When I think of things that would impact investors, not a whole lot. The tax rates haven't changed, the way dividends are treated isn't any different.

The only other thing that I would think through that is changing is some of the new 1099 reporting. And we have new rules associated with that, where brokers are now required to track basis, and I think the important part from an investor's perspective is to understand what method of basis tracking is being elected by default for your accounts that you have--meaning, is it a FIFO basis or is it some other average cost basis that's being elected? It's important to understand what the defaults are, and to determine whether those are most appropriate to your tax situation, and understand what your other alternatives are, and perhaps make those elections. It's critical to make those elections before you do any sales in the new year.

Stipp: Greg, along those lines, with that new record-keeping that's going to be required, is that going to be only looking forward, or is there also going to be a historical way that they have captured that in the past? Or is it something that you still need to keep track of for your past investments?

Rosica: Right. It is only looking forward. So it only requires new purchases that are being made. And so it's still incumbent upon taxpayers to do the historical tracking and know where those are. But also to understand when you're selling assets, whether it's stocks or mutual funds, which lots you are selling, which groups of basis that you are selling, and whether you want to sell the low basis ones or the high basis ones first.

Stipp: And last question for you, Greg, I think when you talk about keeping track of cost basis and other things like that, it's a lot of work that investors have had to do in the past. And I know that taxes, a lot of times, people will put it off, because they do know that there is a lot of record-keeping involved. What are your tips for being able to more organized and perhaps take some of that stress and hard work out of the tax-filing task?

Rosica: So, clearly, going forward from an investment perspective, it's going to get easier over time as basis is calculated and tracked by brokers. But I think, it's still incumbent upon the taxpayer to make sure that they're keeping track of that, that they are able to verify it. So, I think using many of these different electronic software packages that are available or online accounts to be able to download that information and track it, can work very efficiently--whether it's your broker's website or whether it's a third-party accounting software for personal accounting, a lot of that stuff is really push-of-the-button download, and you can track those things very easily on your own home PC.

Stipp: Greg Rosica, contributing author to the Ernst & Young Guide for 2012, thanks so much for calling in today and offering those timely tax tips.

Rosica: My pleasure. Thank you.

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