Guideposts in an Uncertain Tax Environment

Jason Stipp: I'm Jason Stipp for Morningstar.

Investors are facing a very uncertain tax environment with the threat of rising taxes in 2013, but not the certainty of rising taxes in 2013.

So what should investors do? We’re checking in today with Joel Dickson--he's a principal and investment strategist at Vanguard--to get some insights on how investors might think about all of these uncertain taxes that could be coming up. Thanks for joining me, Joel.

Joel Dickson: Thanks for having me, Jason.

Stipp: We do have this uncertain environment. We could have capital gains rates going up in 2013, dividend tax rates going up in 2013. Investors don't want to be hit with these higher tax rates, but they also don't necessarily want to have the tax tail wag the dog. What should we do in an environment where we just don't know?

Dickson: Let me start by saying, while we may not want the tax tail to wag the dog, a happy dog does wag its tail. So we need to think about how you do incorporate tax issues into your overall investment program.

In many ways, the situation that we are facing right now, and this being October 2012, is not that different from where we were exactly two years ago, because many of the exact same tax rates that are scheduled to rise at the beginning of 2013 were scheduled to rise at the beginning of 2011.

Ultimately, they did not, given some last-minute extensions that were done in the middle of December 2010. And the important part of that is, the lesson that people learned is, if you started reacting to what you think might happen in a period of substantial uncertainty, you may have done yourself more harm than good by trying to anticipate it.

The nice thing with these tax changes, if you will, is that, we'll have a lot more information come December and maybe even after that. And so you don't need to react now. It is something where, if it's capital gains, if it's dividends, and so forth, those are decisions that can be made closer to the end of the year when we have additional information.

Stipp: We have heard from some of our readers that they’re thinking about tax gain harvesting. So you often think about tax loss harvesting around this time of year. But in this case, they would go ahead and take a gain on something that's appreciated, pay what they hope will be lower rates in anticipation that those rates might go higher next year. And in fact they might buy that security back if they still wanted to have that exposure. What do you think of that as a strategy if you are just convinced that these rates are going go up?

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Dickson: When I normally think about tax motivated strategies in a portfolio, I really think about three things, but in terms of the gain harvesting, two come to mind immediately.

One is, often you talk about wanting to defer tax realizations.

The other is that you want to change the character of the income from higher tax to lower tax rates. And what we are talking about with this gain harvesting scenario is that second one, where I am seeing the possibility of higher tax rates in the future; if I can lower my tax rate today, it may actually make sense for me to accelerate that tax liability. The problem with that is, again, we're in a very uncertain environment. We don't know, in fact, if capital gains tax rates will be higher next year than they will today.

In addition, you could actually find yourself in a position of, counterintuitively, ending up paying higher taxes, even though you might've done it for the right reason, if you had lower taxes this year. Let's say, you reset your basis, you've had a long-term capital gain this year. Let's say the market continues to rise for whatever reason. And next year, you have to sell it, there is something going on. Well, now all of a sudden that's a short-term gain. And if income tax rates have gone up because you reset your basis and now have a short-term gain realization, you could actually end up net-net in a worse spot. So, there are a lot of moving parts in trying to engage in that type of strategy. And that's why, again, given the uncertainty, I think one good thing is to sort of wait it out at this point.

Stipp: So, we know we have uncertainty right now for 2013. I think that a lot of investors also see longer-term uncertainty given the budget situation. A lot of folks think [taxes will] have to go up over time, over the long-term time horizon. So in some ways, I think the Roth conversion is also kind of that decision of, do I want to realize some gains now at a rate that I know, thinking that tax rates could be a lot higher down the road.

A lot of people think this is potentially a good evergreen kind of consideration--of course, it's always personal--but given that we do have uncertainty short-term and potentially longer-term, are there any kind of rules of thumb that investors should at least take a look at to try to minimize their tax liabilities?

Dickson: Well, and Jason that gets to that third sort of thing that I think about when we talk about taxes and portfolios, and that's the concept of tax diversification. And we at Vanguard have been talking about that since the 1997 Tax Reform, when the Roth IRA first came into play.

The idea here is that much like an investment portfolio, I don't know if large-cap stocks or small-cap stocks are going to outperform over the course of the next 10 years. So, what do I do? I invest in both because it diversifies my outcome. Yeah, 10 years from now, I'm going to look back and go, I wish I'd had all my money in, let's say, large cap had been the better performer. But we don't know that at this point in time. You can take that exact-same concept and apply it to tax outcomes.

We don't know what the tax environment is going to look like over the next 10, 15, 20 years. By the way, tax rates might not go up. We might lose deductions and exemptions, and you might see tax rates stay the same or maybe even go down under some proposals. The point being that you can structure a portfolio for tax outcomes recognizing that you're not going to get it perfectly right, just like you can for investment outcomes. And a great way is exactly the way that you talk about, which is a Roth conversion or a Roth IRA, or Roth 401(k). The difference being from a traditional 401(k) or IRA that you pay the taxes now in order to avoid taxes, whatever the tax rate might be, in the future.

The one big uncertainty with traditional IRAs and 401(k)s is that you don’t know what tax rate you’re going to be paying in the future. The idea, of course, is that, well, if I defer now and pay in the future, I’m likely to have lower income in retirement and that may or may not actually attribute to a lower tax rate. And what matters ultimately is the tax rate that you pay, and by having both, you can have that tax diversification and it insulates you from sharp moves one way or the other.

Stipp: So if you need some extra funds in one year in retirement, and you’re bumping up against the taxable kind of income that you would want to take, you could take some from that Roth?

Dickson: Use the Roth, exactly.

Stipp: Last question for you is on dividends. So we know that dividend tax rate could go up. Dividends obviously are very popular right now for a number of reasons, but do you think that a higher dividend tax rate might change the thinking on dividends on several levels? Corporations maybe would be less willing to pay them and might want to do more buybacks because of different tax treatment, or managers might not want to have the dividend-producing income in their mutual funds for example. What do you think some of the knock-on effects, if any, might happen with a higher tax rate on dividends?

Dickson: Well, some of it is hypothetical. The higher dividend tax rates that may come into play probably would reduce payout ratios a little bit from corporations. It also may have a secondary effect of favoring debt finance, too, because interest income is tax deductible and now all of a sudden if you have higher taxes ultimately to investors and so forth, it can affect how firms think about the capital structure, the cost of the capital, and so forth, because really investors should be thinking about the aftertax return that they’re getting on their investments, and so higher dividend tax rates can certainly affect that.

That said, I have to admit, we’ve been a little bit concerned with this substantial yield focus that investors have had over the course of the last couple of years. And a lot of that has manifested itself in a shift from bond investments to dividend-paying equity investments in a lot of investor portfolios. You look at cash flows and so forth, you see really in the recent period, very different behavior than you’ve seen in the past. A lot of times--past performance can drive a lot of cash flows into mutual funds. We’re actually seeing a lot of cash flow into yield product that seems unrelated to past performance. So you really do see this search for yield going on.

The problem that we see with that is, especially if you are going from bonds to stocks, those are fundamentally different in terms of being risky assets. You have really changed the riskiness of your portfolio in the search for yield. We think that's potentially a fairly dangerous outcome, because investors changing their risk profile from what they're comfortable with could come back to hurt them.

Stipp: Especially investors often are near or in retirement when they have that income focus, and probably less risk tolerant. I would say even moving from intermediate-term bonds to high yield in trying to get some extra yield could make a much rockier ride for them?

Dickson: It certainly can.

Stipp: So Joel Dickson of Vanguard, thanks so much for giving us some guideposts in this very uncertain tax environment.

Dickson: Thanks for having me.

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