What the Tax Deal Means for Your Portfolio Plan

The tax deal that passed through the House of Representatives on Tuesday evening included something for everyone to revile: Tax hawks decried higher taxes on the wealthy, while many on the left rued that Bush-era tax cuts were made permanent. And it's hard not to be depressed that further partisan bickering is almost certainly on the way: Within the next few months, Congress will revisit the debt-ceiling limit as well as spending cuts.

Yet financial planners and tax and legal professionals still have something to cheer about in the wake of the deal: certainty. The past several years have featured many question marks about the direction of tax rates, with various Bush-era provisions facing expiration, being extended, and threatening to expire yet again. In that many of the cuts are now permanent, the newfound certainty in tax rates makes matters of investment, estate, and tax planning significantly easier.

Here are some of the key provisions of the recent tax package as well as what implications they have for your financial and investment plans.

Higher Rates for Higher Earners
What's Happening: Higher income, dividend, and capital gains taxes will kick in for those individuals earning more than $400,000 in 2013 and married filers earning more than $450,000. Starting with the 2013 tax year, those high earners will pay a top tax rate of 39.6% on ordinary income and 20% on both dividends and long-term capital gains.

What You Should Do: If you expect to fall into the aforementioned higher income tax bands for 2013 and beyond, many of the long-standing best practices for tax management will make more sense than ever. Those best practices include maximizing contributions to tax-sheltered accounts such as IRAs and 401(k)s, placing assets with high year-to-year income production (Treasury Inflation-Protected Securities, junk bonds, and real estate, to name a few) in tax-sheltered vehicles. You should then manage your taxable accounts with an eye toward maximum tax efficiency; broad-market stock index funds and exchange-traded funds are good bets, as are municipal bonds. Limiting short-term trading--and in turn the realization of costly short-term capital gains--is another "do," as such gains are taxed at nearly twice the rate as long-term gains. In addition, high-income households with the wherewithal to defray ongoing health-care costs should consider a health-savings account, which remains the only triple-tax-advantaged wrapper in the whole tax code. Contributions go into the accounts on a pretax basis, the money compounds tax-free, and withdrawals for qualified health-care expenses are also tax-free.

Moreover, Congress' willingness to raise taxes on high earners after being largely unwilling to do so for more than a decade--combined with a still-lofty deficit--signals that additional tax increases could loom in the future, and not just for those in the highest income bands. If you're a younger person with many years of earnings power--and the potential for earnings growth--ahead, contributions to Roth IRAs and 401(k)s, which allow for tax-free compounding and distributions, look like a no-brainer.

Tax Parity for Dividends and Long-Term Capital Gains
What's Happening: Although the tax on dividends was set to increase to investors' ordinary income tax rates starting in 2013, the new law will keep the tax on dividends and long-term capital gains linked. Most taxpayers will continue to pay a 15% rate on both dividend and long-term capital gains, the same level in place since 2003. Meanwhile, single taxpayers earning more than $400,000 and married couples filing jointly earning more than $450,000 will pay a 20% tax rate on dividends and long-term capital gains.

What You Should Do: Dividend-focused stocks rallied hard on Wednesday, the first trading day since the tax deal passed, and tax-aware dividend-focused investors are apt to be pleased that dividend tax rates will remain in line with long-term capital gains tax rates. Nonetheless, most accumulation-minded investors will still be better off downplaying dividend-payers in their taxable accounts, as I argued in this article. The reason is control: Whereas individual stock investors can delay their realization of capital gains from year to year--and for many years, if they choose--dividends get paid out regardless, and you'll owe tax on that money. That doesn't mean you should shun dividend payers, but stocks and funds with high income streams are a better fit for tax-sheltered accounts like IRAs and 401(k)s than taxable ones. ​

Increased Availability of Conversions from Traditional 401(k)s to Roth 401(k)s
What's Happening: In an effort to raise revenues, the fiscal cliff deal allows employees with traditional 401(k) balances to convert them to Roth 401(k)s, provided their 401(k) plan allows for such a conversion and includes a Roth 401(k) feature. Whereas the Small Business Jobs and Credit Act of 2010 enabled a limited subset of individuals--those who have left or retired from their former employers, are age 59 1/2, or are disabled or dead--to convert their 401(k) balances from traditional to Roth, the new laws enable people of all ages to do so. Partial conversions will also be available. Individuals will be able to convert assets in plans established prior to 2013. 

What You Should Do: Because in-plan conversions allow workers to pay taxes on their balances at today's tax rates in exchange for tax-free withdrawals during retirement, such a maneuver will make the most sense for those who have reason to believe their tax rates will be higher in the future. Therefore, key candidates for in-plan conversions will be the wealthy and younger workers whose careers are on an upward trajectory. The key consideration, however, is whether you have the cash on hand--apart from the assets in the 401(k)--to pay the taxes due upon the conversion.

Long-Term Care Provision of Health-Care Reform 
What's Happening: Originally a component of the landmark 2010 health-care reform law, the Community Living Assistance Services and Supports (CLASS) Act was designed to create a national insurance pool, offered through employers, to help workers pay for long-term care. Yet concerns about the program's financial sustainability dogged it from the start, and it was never implemented. The recently passed budget agreement finally repealed the CLASS Act.

What You Should Do: Unfortunately, the demise of the CLASS Act coincides with dramatic increases in long-term care insurance premiums, owing to both low interest rates and misguided actuarial assumptions about long-term care claims. In the face of these headwinds, would-be long-term care insurance purchasers have a few options. One is to skinny down your long-term care insurance buy, purchasing a policy that provides a baseline of long-term protection but has a longer elimination period (that is, higher deductible) or a lower dollar limit on the amount of benefit you can receive in your lifetime. Would-be purchasers of long-term care insurance who are younger might consider delaying their purchases in the hope that higher interest rates will help tamp down premiums in the future. (If insurers are able to earn higher interest rates on the premiums they take in, that could put downward pressure on premiums.) Just bear in mind that time won't necessarily be your friend: Not only will you face higher premiums as you age, but you're also more likely to develop a health condition that could make insurance costly or out of reach. Finally, you could plan to pay long-term care costs out of pocket. Just be sure to be realistic about the amount of money you'll need to amass; this article provides some guidelines.

And no matter which route you choose, the aforementioned health-savings account is likely to prove a good fit. Monies in an HSA can be used to pay long-term care insurance premiums, and HSA proceeds can also be used to pay for long-term care expenses themselves.

Alternative Minimum Tax
What's Happening: Congress put in place an inflation-adjusted exemption amount for the alternative minimum tax, thereby obviating the need for an annual last-minute "patch" to keep new middle-class taxpayers from falling into the AMT zone. Had Congress failed to take action, an estimated 28 million new taxpayers would have been subject to the AMT for the 2012 tax year, according to IRS estimates.

What You Should Do: Just because the AMT exemption amount will now be automatically bumped up to keep pace with inflation each year, that doesn't mean those who haven't been subject to the tax in the past can breathe a sigh of relief. A host of factors affect a taxpayer's vulnerability to the AMT, both on the tax deductions, exemptions, and credits side as well as on the income side of the ledger, and those items change from year to year. Exercising stock options is a common trigger for the AMT, because the tax recognizes as income the difference between the grant price and the share price on the exercise date. Income from so-called private-activity bonds--municipal bonds issued to finance projects like sports stadia--are also subject to the AMT, even though munis are usually exempt from federal taxes. If either income source is a significant part of your portfolio--or if you take a lot of credits, exemptions, and deductions--a tax advisor might be able to help strategize about how to reduce your AMT-related tax hit.

Estate Tax 
What's Happening: Although the estate tax exemption was set to drop to $1 million in 2013 and the estate tax was set to pop up to 55%, the estate tax exemption will remain $5.12 million per individual, and the top estate tax rate will increase to 40% from 35% in 2012.

What You Should Do: The very high exemption amount may lead all but the highest rollers to think that they don't need to worry about estate planning, but that's not necessarily the case. Regardless of the status of the estate tax, everyone needs to mind basic estate-planning matters, including properly drafted beneficiary designations, guardianships for minor children, and powers of attorney for financial and health-care matters. This article details some of the key estate-planning steps people at all income levels should take.

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