The Error-Proof Portfolio: Anticipating 2013 Tax Changes Could Save You Some Dough

Investors have had a tough slog during the past decade, but you can't say it's because of the tax regime. Dividends, taxable as ordinary income during the late great bull market of the 1980s and 1990s, have been taxed at or below 15% since 2003, provided they meet certain criteria. The same goes for long-term capital gains, which were taxed at rates of 28% or higher as recently as the late 1990s. 

But all of that is set to change in 2013. Barring congressional action, dividends will again be taxable at ordinary income tax rates starting next year, and the highest income tax rate will pop up from 35.0% currently to 39.6% in 2013. Long-term capital gains, meanwhile, will be taxable at 20% for most investors and 10% for those in the 15% tax bracket or lower. A new Medicare surtax will also kick in that will levy a tax on high-income households' investment income, and the estate tax will ensnare many more estates if the exemption exclusion drops to $1 million, as it is scheduled to do next year.

What's a tax-savvy investor to do? First, what not to do: Congress could change its mind on a least some of these measures, so it's a mistake to act preemptively to reduce your tax bill until the new tax rates are a sure thing. Given the way Congress has been working lately (or rather, not working), there might not be clarity until late in 2012.

Nonetheless, getting familiar with these changes, and being prepared to adjust your portfolio strategies to limit the changes' impact on you, can help reduce your tax bill for 2013 and beyond. Here's an overview of what to keep on your radar.

Income Tax
Income tax rates are going up almost across the board in 2013, and the highest tax rate will jump from 35.0% currently to 39.6% in the 3.8% Medicare surtax on unearned income above certain levels (more on this below), and it's clear that certain high-income households could see a meaningful bump up in the taxes they owe beginning in 2013.

Strategies to Consider

• Roth conversion: Individuals will pay ordinary income tax when converting traditional IRA assets to Roth, so converting in 2012, under a lower tax regime, might be better than waiting. (Of course, your own circumstances could push your income higher or lower in those years; check with an accountant or financial advisor to help you crunch the numbers and address your own situation.)
• Cut back on (or eliminate) short-term trading: Gains on securities held less than a year are taxed at your ordinary income tax rate, so higher rates would provide yet another impetus to scale back on frequent trades. If you're a mutual fund investor who owns actively managed funds, focus on those with low turnover rates to keep a lid on short-term capital gains payouts.
• Consider municipal bonds: Even if you're not in one of the higher tax brackets, munis might make sense for at least a portion of your taxable portfolio given higher tax rates; once tax effects are factored in, your take-home yield from munis may be well ahead of what you would earn from a taxable bond or bond fund. Muni funds from Fidelity and Vanguard are among Morningstar analysts' favorites.

Dividends
Qualified dividends, now taxable at a 15% tax rate for most investors and a 0% tax rate for those in the 10% and 15% tax brackets, will be taxable at ordinary income tax rates.

Strategies to Consider

• Revisit asset location: Under the lower dividend tax rates, you might have been inclined to hold dividend-paying stocks and funds in your taxable account. Yet if dividends are again taxed at ordinary income tax rates, that will be a terribly tax-inefficient strategy. Take care before repositioning, though, because selling appreciated dividend payers from your taxable account could trigger a tax bill.
• Use master limited partnerships in taxable accounts: For current income from your taxable portfolio, MLPs will still be OK. The distributions you receive from MLPs aren't taxable as dividends, making these rare income-producing securities best confined to your taxable accounts. 

Capital Gains
The increase in capital gains rates that's set to go into effect in 2013 isn't as drastic as the bump-up in the dividend tax. Capital gains rates for most investors are set to jump to 20% from 15% in 2013; those in the 15% tax bracket will pay tax at a 10% rate.

Strategies to Consider

• Employ a buy-and-hold mind-set and tax-efficient investments: Focus on tax-efficient investments in your taxable portfolio, including individual stocks, exchange-traded funds, index funds, and tax-managed mutual funds, all of which typically keep capital gains distributions to a minimum.
• Unload highly appreciated securities: If you planned to sell or scale back on something anyway, you'll be better off doing so before capital gains tax rates go up. Don't let the tax tail wag the dog, though.

Estate Taxes
Barring Congressional action, in 2013 the estate tax regime will go back to levels not seen in more than a decade, with a 55% tax rate on estates worth more than $1 million. That's quite a turnabout from where things stand for 2012, with the estate tax rate of 35% and estates of less than $5,120,000 exempt from estate taxes. Given that the $1 million amount would affect a broad swath of middle-class households (estates can encompass investment assets as well as residential real estate), it would be surprising if there were no Congressional action, but it's still worth keeping on your radar. 

Strategies to Consider

• Don't let the uncertainty deter you: An experienced estate-planning attorney can create a plan that can withstand a number of different tax regimes. He or she can help you attend to other important estate-planning matters, too, such as naming powers of attorney for health-care and financial matters.
• Gifting: Under a more onerous tax regime, gifting assets to remove them from your estate will be more important than ever. In 2012, individuals can gift up to $13,000 per person per year. Charitable gifts are exempt from the estate tax.

Medicare Surtax
Beginning in 2013, a 3.8% Medicare surtax will go into effect for higher-income individuals (as well as estates and trusts) with net investment income above a certain threshold. Specifically, the surtax will be imposed on the lesser of an individual's net investment income for the year or modified adjusted gross income, or MAGI, of more than $250,000 for married taxpayers filing jointly. (The threshold is $200,000 for single filers.) If your modified adjusted gross income doesn't exceed those thresholds, you don't need to worry about the surtax.

Strategies to Consider

• Take a look at munis (again): Muni-bond income will not be subject to the new tax.
• Investigate Roth conversions: Distributions from qualified retirement plans like 401(k)s are not considered investment income for the purpose of the surtax, and therefore aren't directly subject to the surtax. However, they have the potential to push up a taxpayer's modified adjusted gross income above the thresholds for the surtax, which in turn could subject other investment income to the new tax. Roth IRA distributions, by contrast, don't contribute to MAGI, so converting traditional IRA and 401(k) assets to a Roth could reduce your vulnerability to the tax. Check with a tax advisor before undertaking a conversion.

 

 

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