Planning for uncertain times

October 23, 2012 

Unless Congress and the president can agree on a compromise before the year ends, the Bush-era tax cuts will expire on Jan. 1 -- potentially exposing millions of individuals and families to higher tax rates.

If the Bush tax cuts expire, most taxpayers will face some combination of higher tax rates on their incomes, dividends and capital gains in 2013. In addition, high earners will pay an additional 3.8 percent tax on their investment income and a 0.9 percent higher Medicare tax as legislated by the Patient Protection and Affordable Care Act better.

The top tax rate on dividends, 39.6 percent before Bush and 15 percent for qualified dividends now, could become 43.4 percent in 2013 if nothing is changed. The long-term capital gains rate, 20 percent before Bush and 15 percent now, could increase to 23.8 percent.

The estate tax, 55 percent before Bush, 0 percent in 2010 and now 35 percent

could return to 55 percent. Finally, the estate and gift tax exemption, which before Bush was $675,000 for married individuals and is now $5.12 million, is scheduled to go back to $1 million.

While smart tax planning is practical in any environment, it's even more prudent when there is the potential for significant tax increases. Listed below are some tax-smart strategies you may want to consider:

1. Max out retirement plans.

Whether or not taxes increase, it may make sense to fully fund your company retirement accounts and/or IRAs. One of the primary advantages of participating in a traditional IRA or an employer-sponsored retirement plan such as a 401(k) is that the money you contribute in a given year may be tax deductible. And because these are tax-deferred accounts, you do not pay income taxes on any earnings on your investments until you withdraw funds.

2. Consider a Roth IRA conversion.

While income limits may preclude some investors from contributing to a Roth IRA, anyone can do a Roth Conversion by converting eligible funds from a traditional IRA or employer-sponsored retirement plan to a Roth IRA. Converting to a Roth IRA can provide tax-free income in retirement, and now could be an ideal time to convert some of your assets before a potential increase in income tax rates, which may come next year.

3. Review highly appreciated assets.

If the capital gains tax rate increases from 15 percent to 20 percent, investors will pay a third more in taxes on both liquid and illiquid assets in 2013. Evaluate stocks, mutual funds and even privately held businesses -- with an eye to future performance -- and consider capturing current gains before any potential rate hikes go into effect.

4. Give increased attention to buy-and-hold strategies.

If the tax rate on capital gains increases, the tax benefits of buy-and-hold strategies can become more valuable. Similarly, it becomes more important to harvest tax losses in order to shelter gains that otherwise would be taxed at the higher rate.

5. Augment your tax-advantaged investments with municipal bonds.

Since municipal bonds are federally tax-free and generally free from state and local taxes, they are one of the most efficient investments available for defending against current and potentially higher tax rates. If income tax rates do rise, interest income earned on municipal bonds will feel little if any impact.

Gary W. Plum, first vice president, financial adviser with Morgan Stanley in Bradenton, can be reached at 941-714-7939.

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