Sturdy Shelters for a Cloudy Tax Forecast

Jason Stipp: I'm Jason Stipp for Morningstar. With the pending sunset of Bush-era tax cuts, there is plenty of uncertainty for investors' tax liabilities in 2013. But Morningstar's Christine Benz, director of personal finance, says there are some steps investors can take today to position themselves well for a variety of tax environments. She is here to offer some tips today.

Christine thanks, for joining me.

Christine Benz: Jason, great to be here.

Stipp: There are a variety of tax changes that might happen at the end of the year if Congress doesn't take action. Can you tick through some of the big ones?

Benz: Well, income tax rates are set to go up, so the highest rate will go from 35% to nearly 40% in 2013.

Dividend tax rates are set to go from their currently low 15% for most investors back up to your ordinary income tax rate.

The estate tax is set to affect estates over $1 million and will jump from 35% to 55%.

Capital gains tax rates are going up, and then we're also going to see, Jason, this new Medicare surtax going into effect as well. That will be a 3.8% tax, and it will affect the lesser of your net investment income or any of your adjusted gross income that comes in above a certain threshold.

Stipp: So, that, Medicare's surtax looks like it probably will happen because it was a part of that health-care package that the Supreme Court basically reaffirmed with their decision.

The other tax increases, though, may or may not happen depending on whether Congress acts to extend those earlier tax cuts. This leaves investors in a tough spot because they don't know whether they're going to be on the hook for higher tax bills next year.

Benz: Right. A lot of investors have been chattering about what strategies can they take, if indeed taxes do go up. When you look at the deficit, I think a lot of people say, well, realistically we probably will see higher taxes at least on some of these things. So, one strategy that I know a lot of our users have been talking about is, if they have long held winners in their portfolio, maybe pre-emptively selling them at today's relatively low capital gains rates, and they can even re-buy the same position after they have made the sale, and there is no wash-sale rules or anything like that that governs taking a tax loss. You can actually do that and not undo the tax advantage of selling at the lower capital gains rates.

Stipp: So, certainly if there are some positions that you were thinking about cutting anyway or trimming anyway, to do it this year versus next year, if it was a decision you were going to make anyway, it could make sense given that there is a likelihood that we could see those higher tax rates next year.

But also in addition to some of those plans investors might already have, you have some evergreen tips for investors that can help with their tax positioning, and basically good things for them to do whether or not we see these tax rates. The first one has to do with your tax-advantaged accounts and how you use them, so especially the Roth versions of those accounts. Why is Roth in this environment particularly attractive?

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Benz: Well, a couple of big advantages. One is, if you think that tax rates, either for you personally or for the U.S. population as a whole, if you think that income tax rates will go up, you'd be better off paying taxes at today's rate versus higher rates down the line. So that's where Roths have an advantage, because you're able to pull your money out tax-free in exchange for paying taxes today, so there is that benefit.

There is also a benefit with this Medicare surtax. So, no IRA distributions count as net investment income for the purpose of this surtax, but Roths withdrawals have an extra advantage because they don't push up your adjusted gross income in the year that you do that withdrawal. So there is another advantage there from that standpoint.

The other big advantage--and I would say it's kind of an evergreen advantage for higher-income retirees who don't really need to take distributions from their Roths during retirement, they're not required to do so, in contrast with traditional IRA and 401(k) assets. So, I would say that there are just a lot of things lining up in favor of Roths. When you read things that accountants put out about the tax law, I would say there is the most enthusiasm for Roth relative to any other mechanism out there.

Stipp: Sounds like a lot of benefits generally for Roths. So if a conversion to a Roth from a traditional IRA is something that you were considering anyway, it sounds like 2012 could be a good year to really look at it very closely, given that we could see higher taxes in 2013.

Benz: I think that's right. So, you'll have a higher income tax rates to contend with potentially in 2013. You will also potentially see your adjusted gross income go up when you do the conversion, and that could also increase your susceptibility to the surtax. So, that is a good reason to think about actually doing the conversion this year versus next, but I always say, check with the tax or financial advisor to help you think through the scenarios.

Stipp: So, absent the tax uncertainty, as you said, there are personal situations that might dictate whether a conversion makes sense for you or not, which you should also consider in addition to the fact that we could see higher tax rates. What are a few of the other major considerations before you do a conversion?

Benz: It's so individualistic, Jason, but I would say, for example, if you think for whatever reason you'll be in a lower tax bracket in 2013 than you are this year, maybe it will make sense to actually wait rather than doing a conversion this year. So it is very individualized.

It's also important to think through if you are someone, for example, who is nearing retirement and you know you haven't saved very much. For that person, chances are they will be better off just hanging on to their traditional IRA or 401(k) assets, certainly, rather than contemplating any sort of conversion, because they personally will owe income tax at a lower rate in the future than they do today.

Stipp: So lots of things to consider in doing a conversion, but given the 2013 potential uncertainties, better to get started now versus later, so that if it looks good for you, you can go ahead and get it done.

Benz: Absolutely.

Stipp: Okay. So, we talked about Roths, and Roths look particularly attractive, but tax-sheltered accounts in general could also be attractive in an uncertain tax environment.

What are some tips to think about all of your tax-advantaged accounts right now?

Benz: Certainly think about maxing out any tax-sheltered accounts you have available to you, if you are still in your accumulation years. Think about making the maximum allowable contributions to those accounts.

And there are a few separate benefits that I see as sort of evergreen benefits, regardless of what happens to the tax situation. The first is that you will defer income and capital gains taxes on a year-to-year basis, so you'll have that tax-deferred compounding working in your favor. If you make deductible contributions either to a traditional 401(k) or an IRA, you are able to reduce your gross income in those particular years.

Those are just a couple of reasons that I would think about making sure that you are taking maximum advantage of those accounts.

Stipp: So when you're thinking about that tax deferral that's happening right now in those accounts, what kind of investments then would you think for putting into these accounts. You say you want to max them out, so what should you be investing in?

Benz: In general anything that has a heavy tax burden from year-to-year is going to make a lot of sense for those tax-sheltered accounts. So anything that's kicking off income that's taxed at your ordinary income tax rates--so that's bonds, definitely real estate (REIT) income is there. TIPS--Treasury Inflation Protected Securities--I would certainly put in that category. Junk bonds. Anything that has a heavy tax burden in terms of ordinary income tax would be something to consider tax sheltering.

I also am a believer in putting dividend-payers within tax-sheltered accounts to the extent that you can take advantage of them, and the general philosophy is that all things being equal, you would rather have more control over when you receive some sort of dividend or capital gain or whatever it is from an investment, versus automatically receiving it as you do with dividend-payers. So, you'd want to shelter those dividends within the confines of a tax-sheltered account.

Stipp: When you think about Roth versus traditional here, are there any differences--given that Roth you are not being taxed later on, you are paying that tax upfront--in the kinds of assets you may locate in a Roth?

Benz: Well, that's a really good point, Jason. So, I would carve Roths out, because when you think about the sequence of withdrawals that will make sense to stretch out that tax-saving benefit you get from Roth assets, those are going to be the longest-term assets in your portfolio, usually the last one in the queue to get tapped during retirement. So you'd want to think about them as being your highest growth assets. So it turns what I just said on its head in that you would typically want to keep stocks or whatever your highest-growth-potential assets are, in the Roth accounts.

Stipp: So the tax-sheltered accounts obviously give you that shelter from the dividend taxes you might otherwise pay, or capital gains taxes, you might otherwise pay. What about the Medicare surtax? Is there a benefit for these tax-sheltered accounts and what you might pay on that front?

Benz: Definitely, because with this Medicare surtax, a lot of things are actually exempt from net investment income, they're not considered net investment income. So that would be distributions from 401(k)s, IRAs, pension income, Social Security income, capital gains from the sale of a home--a primary residence--provided that your capital gain falls below a certain threshold. So you want to keep that in mind when thinking about what you put where.

Certainly, if you have taxable assets, as a lot of retirees do, the name of the game with them is to try to keep the net investment income that they are kicking off to as low a level as you possibly can, because that's the stuff that will in fact be subject to the surtax, provided your adjusted gross income is also above the thresholds.

Stipp: And speaking about asset location, as you mentioned there, we talked about some of the things you may want to put in tax-advantaged accounts, but you also do have these other accounts and you are thinking about what assets to put where. Given that we do have this uncertainty, what are some general rules of thumb about asset location that you might pose for investors to position themselves well?

Benz: Well in terms of the taxable accounts, I think you just want to think about holding assets that are tax-efficient. So that would be individual stocks, broad market index funds and ETFs, municipal bonds to the extent that you need safe securities in your taxable accounts. Run the numbers, look at whether on an aftertax basis the municipal bond or bond fund makes more sense for you than the taxable bond or bond fund.

Stipp: On the muni front, I know, those can be attractive for folks especially in some of those higher brackets, but there has been a lot of concerns lately about credit risk. How can you reduce some of those risks, if munis are looking attractive from a tax standpoint?

Benz: I think a fund is a great place to start. So you get that diversification across many issues. You also get professional management. I don't know if you have ever tried to research an individual muni, Jason, but it can be a really tricky, not-so-transparent environment, and smaller investors can also encounter a quite unfavorable bid-ask spread environment. So they might get really hurt on the trading costs.

So for a lot of reasons, I think a mutual fund makes sense. Also unless you are receiving a huge tax break for investing in your home state munis, I generally favor the geographically diversified funds versus the ones that home in on California or whatever the single state bonds might be.

Stipp: That muni income is obviously tax-advantaged from the regular income taxes that you would pay, but what about that calculation for the Medicare surcharge? How does muni figure into that?

Benz: It's a big win in a lot of ways. The key way is that it doesn’t count as net investment income, nor does it count toward your adjusted gross income. So it has kind of a double benefit from the standpoint of this surtax.

And I think, frankly, even though municipal bonds have had a really nice run here, and a lot of our analysts, I know, are saying to keep your expectations in check, I suspect that this could provide potentially a little bit of a demand tailwind for munis from upper-income investors who might otherwise be hit by this surtax. So something to keep an eye on, I think, definitely to something to run the numbers on, if you are in a higher tax bracket.

Stipp: Well it sounds like the bad news is a big cloud of uncertainty on the tax horizon, but the good news is, these evergreen tax best practices could help you in any number of environments.

Benz: A lot of the same principals still make sense.

Stipp: Christine, thanks so much for joining us today.

Benz: Thank you, Jason.

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