April 15th is like a national appointment with the dentist. It’s painful, expensive, and all you want to do is forget about it until next year. But just like promising yourself that you’ll become a “faithful flosser”, so it might be wise to take a “preventive maintenance” look at your finances now to ease the pain of next year’s annual appointment with the IRS. Let’s start with a review of some of the proposed tax changes. First, because this is a term you’ll hear a lot in the coming debate, we should define “high income earner (HIE)”. Typically, for purposes of proposed legislation, this means any individual with gross income of more than $200,000, or any couple with gross income above $250,000. That said, here’s a brief overview.
- Tax cuts for high income earners would expire, with marginal tax rates going from 33% to 36% and 35% to 39.6%, respectively.
- Tax on certain dividends would increase from 15% to 20%.
- Long term capital gains tax would increase from 15% to 20%.
- Deductions for high income earners would be capped at 28%.
- 3.8% Medicare tax would be levied on investment income for high income earners starting in 2013.
Taking the dental analogy further, the federal government is less like your own gentle and benevolent DDS, and more like Steve Martin, the back alley butcher dentist in the Little Shop of Horrors. And he’s got a big boat payment due this month. So here are four things to consider that may help you avoid the dubious title of “high income earner”.
- Discretionary income sources – Look at your taxable income, and determine which pieces you have control over in terms of timing and amount. These would include things like IRA withdrawals, bonus income, deferred compensation, and capital gains. Not only would you want to limit these to avoid becoming a HIE, but it also may make sense to realize some of this income and pay taxes on it in 2010 if you determine your tax rate will be going up substantially in coming years.
- Roth conversions – The panacea of a Roth conversion could emerge from the shadows in 2011 and 2012, and be much hairier than when you shut that cellar door in 2010. This is because financial salespeople are peddling Roth conversions on the premise that the taxes can be paid in 2011 and 2012. True enough, except that if your marginal tax rate goes up and triggers higher taxes on dividends and capital gains, the benefits of conversion could be lost. So if you’re converting, get out your calendar, and put a big red X on December 1, 2010, to take a hard look at whether you want the conversion taxed in 2010, or over the two years 2011 and 2012, or even whether to recharacterize and forget the whole thing.
- Annuity distributions – Unlike regular brokerage holdings, annuities do not benefit from a step up in cost basis at the owner’s death. This means that if you’ve accumulated substantial annuity balances, your children will owe income tax on the gains if they inherit it. So if you’re in a lower tax bracket than your children, you might consider making some withdrawals now and repositioning them in other investments.
- Tax exempt bonds – Long considered the red headed stepchild of investments, municipal bonds are gaining appeal. Consider an HIE in the 36% bracket, with $1,000,000 in corporate bonds yielding 7%. After state and federal income taxes, that $70,000 in annual income could be reduced to $40,000, and worse, trigger the eventual Medicare investment tax. So if you could find municipal bonds yielding more than 4% you might come out ahead. The trick right now is to avoid the long maturities that could experience significant price depreciation when rates rise, without sacrificing yield. Bond investing is not for amateurs, and this requires professional guidance.
The bottom line, and a theme you will fund recurring if you tune in often, is that there is no substitute for competent and objective advice in determining what all this means for you specifically. Our firm is pro-actively focused on the risks our clients face, whether to the holdings in their investment portfolio, or to their finances resulting from factors like taxes and inflation. The changes in the market, the economy, and to our tax laws make it more important than ever to have a trusted and knowledgeable advisor. So brush twice a day, floss regularly, and apply some similar principles of preventive maintenance to your finances, or – put your money where your mouth is.