Strategies Today for Higher Taxes Tomorrow

Christine Benz: I'm Christine Benz for Morningstar.

Some significant tax law changes will go into effect in 2013, several of which have significant implications for investors.

Here to discuss some of them with me is John Pitlosh. He is a Financial Advisor with Investor Solutions LLC.

John, thank you so much for being here.

John Pitlosh: Pleasure to be here.

Benz: There are some notable tax changes that are set to go into effect in 2013. We're set to see an increase in capital gains taxes, and perhaps an even bigger change is that the currently low taxes on dividends are set to go back up to an investor's ordinary income tax rate.

So, John, I would like to get your take on how investors should think about positioning their portfolios ahead of those changes going into effect?

Pitlosh: Well, I think the real issue is--just looking at the political environment and how do you plan an income and savings strategy when the political environment is so bipolar. And everybody knows that our government needs revenue and that we need to cut costs. So you have to just kind of assume that ... taxes are going to be higher, and that they need to be able to plan for them, and given the way the gridlock is right now, the path of least resistance is that Congress is going to do nothing, and we're going to have to deal with what's already on the books. What's already on the books isn't all that pleasant for the average investor, especially the past couple of years that we've just had in terms of pretty lax and easygoing for the average investor.

Benz: Right. So, dividend taxes have been nice and low, capital gain taxes have been relatively benign, and most investors haven't had much in the way of capital gains. Do you think investors should wait until there is more clarity on what's actually happening before they start positioning in anticipation of these changes?

Pitlosh: Well, I think people need to look at 2012 now because there is a lot of opportunities knowing that the future is very uncertain and likely to get worse.

Benz: So, give me a couple of examples of what opportunities might be.

Pitlosh: So, for example, this is the first year that I have actually looked at realizing capital gains for clients knowing that this year it's 15% and even 0% for some lower income people, and next year, the exact same situation that people could be taxed at 23%, 23.8% if you factor in the potential health-care surtax.

Benz: Right. So, if you were going to sell something anyway you should sell it ahead of the increasing capital gains taxes?

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Pitlosh: This is the challenge. ... When we do projections for clients, we actually look at multiple years and try to take a look at maybe a three-year picture of what their tax situation will look like, and when we're doing that for clients now, we're seeing that the difference between 2012 and 2013 can be huge. So, I mean, just back to your point, we are seeing a lot more clients wanting to realize at lower marginal rates as well as lower capital gains rates.

Benz: Now, how about the dividend piece? I know that some people have said all along, well, you probably shouldn't hold dividend payers in your taxable accounts, but I know that some investors have been doing that. What would you say to them? Should they just wait until there is more clarity, or how would you address that particular issue, because, in some cases, selling to do the repositioning could result in capital gains taxes.

Pitlosh: Right. So, if dividend-paying stocks are part of your portfolio that really shouldn't change what you're doing overall. Maybe you might you change the location of your dividend-paying stocks and move some of them into maybe a tax-deferred account, and then maybe substitute that with some municipal bonds in a taxable account, but overall, your investment strategy is based on what your goals are, what your risk is, and you shouldn't let taxes completely wag the tail in terms of the dividend issue. Because people are investing in MLPs, they're investing in emerging markets, they're investing in REITs. So, there are lots of other things that don't have great tax consequences, either. So, you want to invest for returns and then kind of balance everything out with what's practical.

Benz: Okay. Now, John, you mentioned this health-care surcharge that's set to go into effect in 2013. I think a lot of people had not been following this too closely. So, I am hoping you can first outline what it is, who it will affect, and what the implications are.

Pitlosh: So, the health-care taxes that are going to be coming on the books in 2013 are really two pieces. There is one that's going to be kind of a supplement to Medicare wages that people in the higher-income tax bracket are going to get hit with. So, for married, filing jointly people, they're going to get hit with additional--I think it's about 0.9% on their payroll tax once they go over $200,000 in terms of withholding, but the tax would be applied at incomes for married filing joint over $250,000.

Benz: Okay. Then there is also a tax that will affect investment income. So, let's discuss that piece.

Pitlosh: Right. So, this is the one that more people are concerned about, especially retirees, because a lot of people think they're going to get hit with this tax once they retire, and in a lot of cases, I am finding that very likely is the case.

Now this tax is the Medicare investment tax, and this is an additional 3.8% that is applied to income, again, over the $250,000 mark, and that tax is being applied to investments on dividends, capital gains, as well as rents and royalties and things like that--and even annuity income.

Benz: Okay. So, are there any strategies that you would recommend to help minimize the blow from these new taxes going into effect?

Pitlosh: Well, I mean right now in 2012, there is some opportunities to maybe reposition some income, do some Roth conversions, maybe pull some more money out of ... I have a lot of clients that are retired and they're pulling money from their IRAs. So, maybe pulling more income out of their IRAs this year and building up taxable accounts and other accounts that ... you're not forced to take distributions from.

So, really, it all boils back to being flexible with what it is you're doing so that no matter what the tax situation is, you have some ability to play with what's available to you, and frankly, are not forced into a bad situation.

Benz: Right. So, if you have a financial or tax advisor, it sounds like this is something to bring up with that person and maybe run through your particular situation to get some guidance on how best to manage?

Pitlosh: Right. So, I mean in 2012-2013, a proactive CPA, an advisor, are literally worth their weight in gold.

Benz: John, another thing that is coming up for 2013 is that there will be a phase-out of itemized deductions, again for higher earners generally. Discuss what's going on there and what constitutes a higher earner. Who should be aware of what's going on with this phase-out?

Pitlosh: So, this itemized deduction phase-out is something that hasn't been applied since 2010. Back then the phase-out for the income was, I think, roughly $166,000, but that mark is going up with inflation. So, I think it will probably be somewhere around $200,000--I don't know the numbers to be exact. But it should be right around that $200,000 range.

Benz: So, if you have an income above that level, does that mean that there are limitations on how may itemized deductions you can take or how much in total itemized deductions?

Pitlosh: What happens is, if you are over that limit, they're going to take 3% of what you're over that phase-out amount. So, let's say you have $250,000 worth ... if your income is $250,000, you would subtract [the $200,000 phaseout, which leaves] $50,000 [in excess] and then you would multiply that by the 3%.

Benz: Okay. Well, John, thank you for this very helpful rundown of what people should have on their radars for 2013.

There is a lot of uncertainty, but I think that what you're saying is it definitely helps to think about these changes, know what they are, and plan ahead where it's prudent. So, thank you so much for sharing your insights.

Pitlosh: Okay. Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com