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How Can You Adjust to the New Tax Increases?


High-income earners are being hit with new taxes this year, but they also have options to minimize the impact of the tax hikes.

Couples earning $250,000 ($200,000 for singles) will be paying an extra 3.8% on investment income, known as the Medicare tax. Couples earning $450,000 ($400,000 for singles) face the new 39.6% tax bracket as well as a 20% tax on long-term capital gains and dividends. There are also phase-outs of exemptions and phase-downs of itemized deductions.

If you are caught in these new tax rates, here are six strategies that may help you.  Please confer with your CPA for specific advice.  Use these as a conversation with your CPA.  If you need a qualified CPA that will work with you for your specific circumstances, I will be happy to refer you to some excellent professionals.

  • Pay down any debt you may have.  The best bond like investment is usually paying off your mortgage. The argument becomes far more compelling if you are caught in the new 3.8% Medicare tax and possible phase-downs of deductions. That’s because reducing interest expense isn’t subject to the 3.8% tax; the income you would have on the interest from the bond is.
  • Defer capital gains. Active mutual funds and account managers generate capital gains. If you are now paying 20% on those long-term capital gains, your tax penalty just went up by a third–plus that pesky 3.8% Medicare tax. Thus, avoiding over-active funds and managers becomes even more important. It’s much better to defer these gains, as your income will drop in your retirement years, and you could then pay the lower 15% capital-gains rate and hopefully avoid the 3.8% Medicare tax. It’s also possible you could avoid paying capital-gains tax altogether since Congress let the step-up basis stay, meaning that your heirs could inherit your portfolio with the cost basis at the date of your death.
  • Stop chasing dividends. Total return is comprised of dividends and stock appreciation. Last year, dividend stocks were dogs relative to the market as a whole, though some years they do better. If you are now paying 20% on dividends, it’s even more important to not overweight dividend stocks, especially since you’ll also be paying the 3.8% Medicare tax on top of this increased dividend tax.   Don’t get me wrong by avoiding all dividend paying stocks.  Many are quality investment.  Just don’t go overweight.
  • Stop buying junk. Many investors are now buying the higher-yielding lower-quality bonds that got clobbered so badly in 2008, when stocks also tanked. Higher taxes mean you will now be getting a lower after-tax reward for taking this risk. Because the key role of fixed income is to act as a shock absorber when stocks plunge, higher tax rates strengthen the argument to stick to lower-yielding high-quality bonds. There is a reason non-investment grade bonds are called “junk.”
  • Consider tax-exempt income. Most municipal bonds, or munis, are tax-exempt and not subject to these new taxes. Thus, if you are hit with these tax increases, the case for munis is even stronger. Keep in mind, however, that munis comprise only about 8% of the U.S. fixed-income market and, with an estimated $2 trillion in unfunded pension liabilities, munis do carry a default risk. Invest in moderation.
  • Never forget asset location. Once you pick an asset allocation, make sure you locate those assets where they are most tax-efficient. It’s now more important than ever to locate income-producing assets in a tax-advantaged account such as an IRA or 401(k).

These are some high-level tax-efficiency ideas and many can backfire. If not done correctly, they could also impact your taxes in other ways, such as triggering the alternative minimum tax. If you are hit with some of these new tax hikes, seek competent tax counsel.

Never forget, however, that your goal should be to maximize after-tax returns rather than just minimize taxes.

Ray A. Hawkins CFP ® ADPASMAWMA®

VP Financial & Estate Planning


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