Taxing Times Ahead

According to one of our founding fathers, Ben Franklin, there are only two certainties in life—death and taxes. Of course, with fate of the Bush tax cuts hinging on the midterm elections, there is nothing certain about future tax policy. We can only surmise that taxes will, one way or another, likely increase at some point in the future.

If the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) (the official names for the “Bush tax cuts”) sunset as originally legislated at the end of 2010, tax rates on ordinary income, long-term capital gains, and qualified dividends will revert to higher, pre-2001 levels.

This table illustrates the differences in marginal tax rates after the sunset:

Marginal Tax Rates
for 2010

Marginal Tax Rates
as of January 2011


(indexed and expanded)









What’s more, investors will also face higher capital gains tax rates. On January 1, 2011, the extension of the capital gain tax reduction sunsets and the tax rate is scheduled to revert from the current maximum rate of 15% back to the 20% capital gain tax rate that was in effect prior to 2003. Some experts believe it will go even higher, perhaps to 25%.

Also, dividends, which under the Bush tax cuts were taxed for the first time at the same low 15% rate as capital gains, will be reclassified and grouped with interest to be taxed at the higher rates levied on wages. Unless Congress acts before the end of 2010, next year the top dividend rate would revert to 39.6%, diminishing the value of dividend paying stocks in a retirement income stream for those in the highest tax brackets.

There are plenty of opinions as to what should be done. The Obama administration’s General Explanations of the Administration’s Fiscal Year 2011 Revenue Proposals sets forth the President’s recommendation that taxes should increase from 33% to 36% for individuals with taxable income greater than $200,000 and couples with a joint income of more than $250,000. The administration also recommends that the top income tax rate of 39.6% be reinstated. (Since 2003, the highest statutory individual income tax rate has been 35 percent.)

With the economy continuing to limp along, the President may have trouble selling his plan to Congress. Surprising new polls show that the Republican Party is predicted to gain seats in Congress in the Midterm elections. To quote Washington insider and CNBC political commentator Greg Valliere, the “Democrats need a pre-election Hail Mary pass” to maintain power on Capitol Hill.

While extension of the Bush tax cuts will remain a hot pre-election issue, it may be December, in a lame duck session of Congress, before future tax policy is resolved. At this writing, experts say the Bush tax cuts will almost certainly be extended—probably for two years—for individuals making less than $200,000 and families that earn under $250,000. However, there’s a growing chance that the Bush tax cuts will be extended, at least for a period of time, for everyone.

Portfolio Strategies for Higher Taxes

Before the celebration begins, however, we need to come to grips with the sobering realization that even if the Bush tax cuts are extended, that simply means taxpayers have been granted a temporary respite from higher taxes. Among other issues, an out of control deficit and the fiscal pressures of retiring Baby Boomers mean that at some point in the not too distant future, taxes, which are currently at modern day lows, will go up. With that in mind, you might consider these portfolio moves:

  1. Realize losses where you have them. Harvesting your losses can shelter your gains from tax while up to $3,000 of net capital losses can be deducted on your tax return against your ordinary income. Any net losses above $3,000 are carried over to future years, and these loss carryovers can offset future realized gains. Obviously, loss carryovers are a valuable asset, especially given that capital gains rates are scheduled to rise.
  2. Accelerate gains. In anticipation of higher tax rates, if your portfolio includes appreciated assets, this year might be a good time to take some gains off the table at the maximum capital gains rate of 15%, rather than the 20% in 2011. Investors in the 15% tax bracket or lower have no gains due on appreciated assets in 2010, but will face a 10% tax in 2011. You might even accelerate the sale of a home or business to avoid higher tax rates down the road. However, if you don’t need the cash from the sale of these assets within five years, it may be more prudent to wait to sell.
  3. Diversify from a tax standpoint. In 2010, the $100,000 income limit was lifted for converting a traditional IRA to a Roth IRA. As things now stand, anyone—regardless of their income—can convert retirement assets from a traditional IRA to a Roth. A Roth’s tax-free qualified withdrawals could be especially attractive if you find yourself in a higher income tax bracket in retirement. Additionally, if future income tax rates truly skyrocket, tax qualified plans may lose some appeal. While Roth Conversions are not optimal for everyone, there are certain conditions which make them favorable, like a drop in income in the year of conversion.

The Bigger Tax Picture

The press has certainly focused on tax changes that impact investors, specifically increasing capital gains rates and dividends reverting to being taxed as ordinary income. However, there are a number of additional changes that could occur if the Bush tax cuts sunset.

If the Bush tax cuts expire, for example, the standard deduction for married couples will return to 167 percent of the single deduction, falling significantly from its current rate of 200 percent. In addition, the child tax credit will be reduced from $1,000 to $500 per child. Dependent care and adoption credits will also be reduced, as will contribution limits and credits for several education funding accounts.

Also, while last year’s Congressional gridlock resulted in a current estate tax of 0 (zero) percent, taxable assets will be subject to a tax of up to 55 percent in 2011 for estates valued at more than $1 million.

The bottom line is that tax policy is in an unprecedented state of flux, and planning can be done only on the basis of educated assumptions and critical thinking with the best information available. We will continue to monitor the debate in Washington and will be prepared to position our clients’ portfolios for any change in tax policy.