Consider These Year-End Tax Maneuvers


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Investing Tip of the Month
By Christine Benz, director of personal finance

Morningstar is available online 24/7 from the Library.

For the past few years, my main tax advice during the fourth quarter has been pretty straightforward: Sell your losers and move on.

That’s because after the 2008-early 2009 bear market, most investors’ portfolios were replete with holdings whose prices were lower than what they had paid for them. By selling those losers out of their taxable portfolios, investors could realize tax losses that they could then use to offset capital gains and, if they had none of those, ordinary income. Doing so is one of a handful of ways to find a silver lining in a tough market environment.

But as we wind down 2010, the calculus for the tax-conscious is far from clear-cut. For one thing, both stocks and bonds have enjoyed robust gains during the past year, improving the odds that you’ll be holding securities at a gain, not a loss. In addition, tax laws are set to change in a big way in 2011, and these changes have significant implications for investors. Although it’s never a good idea to let tax considerations trump investment considerations–and Congress may still take action to alter the tax changes that are set to go into effect next year–it’s still worth bearing taxes in mind if adjusting your portfolio is on your fourth-quarter to-do list.

What’s Changing
So what’s on tap, with regard to taxes, for 2011? For starters, the current 15% capital gains tax rate will jump to 20%. And things are poised to get even uglier for dividend taxation. Most investors currently enjoy a very low 15% tax rate on dividends, and those in the lowest tax brackets currently pay no dividend taxes at all. But unless Congress takes action, investors will owe ordinary income taxes on their dividends beginning in 2011. In essence, dividend income will be treated exactly as bond income currently is from a tax standpoint. There’s widespread speculation that Congress will cap the dividend tax rate at 20% before the onerous new rate goes into effect–thereby once again putting dividends on an equal footing with capital gains from a tax standpoint–but that’s not a done deal.

Additionally, income tax rates are also set to head up next year for higher earners. Those who are currently paying taxes at a rate of 33% will owe ordinary income taxes at a 36% rate, while those in the 35% tax bracket will owe taxes at a 39.6% rate come next year.

If those changes do go into effect, investors might question what kinds of strategies will make the most sense. Consider the following, while bearing in mind that a lot can change between now and year-end.

Strategy 1: Take a Close Look at Big Winners
Tax-loss selling has been a no-brainer for investors’ taxable accounts for the past few years. But this year, another strategy makes even more sense: selling securities that have gone up a lot since you bought them, particularly if you were considering lightening up on them anyway. Say, for example, you put $10,000 into an emerging-markets fund in 2003, and your position is now worth about $38,000. If you rebalanced back to your original position size in 2010 (that is, you sold $28,000 worth of your holdings), you’d owe taxes of about $4,200. But if you waited until next year, your tax hit would jump to $5,600.

Of course, taxes aren’t the only factor to consider in a decision like this. You’ll also want to consider the holding’s individual investment merits, its role in your portfolio’s asset allocation, as well as the potential (however slender) that capital gains taxes won’t in fact revert to 20% next year before pulling the trigger on a winning holding. But if you conduct a portfolio review and determine that some rebalancing is in order, better to sell now than wait until next year.

Strategy 2: Rethink Your Tax-Loss Strategy
While you’re evaluating your cost basis in various securities in your taxable portfolio, bear in mind that tax losses may be more valuable to you in the years ahead, under a higher-tax regime, than they are right now. Of course, if you’re realizing a lot of capital gains this year or triggering a large income-tax bill via an IRA conversion or some other activity, it’s probably worth scrounging up any offsetting losses you can find–regardless of tax rates. It’s also worth bearing in mind that your tax position in a holding is fluid–what’s a loss today may not be tomorrow if the security appreciates. So if you have a losing position you’d like to unload no matter what, you’re probably better off getting rid of it sooner rather than later, even if that loss may carry a greater tax advantage next year.

Strategy 3: Pay Conversion Taxes Now Rather Than Later
For those who are concerned about higher taxes–not just next year but in the many years ahead–converting a traditional IRA to a Roth IRA looks like one of the biggest layups out there. You’ll owe taxes on the taxable portion of your balance when you convert, but you won’t owe any taxes when you withdraw the money. Moreover, in 2010 the tax code eliminates the income limits for higher-income investors to convert in 2010, and it further sweetens the pot for all investors by allowing them to defer taxes due on 2010 conversions into 2011 and 2012.

Converting can make a lot of sense, but conduct a thorough analysis before taking advantage of the government’s offer to push your conversion-related tax burden into 2011 and 2012–especially if you’re a higher-income earner who will be in a higher tax bracket in those years. A tax advisor can help you weigh whether taking advantage of today’s lower tax rates helps offset the opportunity cost of forking over a large sum of money this year (thereby forgoing any gains you’d earn if you hung onto that money and paid the taxes in 2011 and 2012).

Strategy 4: Start Rethinking Asset Location
As I noted above, the taxation of dividends at ordinary-income tax rates beginning in 2011 is far from a done deal. And until there’s more clarity, I’d advise not making radical changes to the dividend component of your portfolio based on prospective tax changes alone. But if you’ve held dividend-paying stocks and funds in your taxable account because of favorable tax treatment, it’s not too soon to think about the implications a dividend-tax increase would have for your asset location–what types of assets you hold in which accounts. Prior to the dividend tax cut in 2003, the classic strategy was to hold non-dividend-paying equities and municipal bonds in taxable accounts while reserving dividend payers and taxable bonds for tax-sheltered accounts. Under a higher dividend-tax regime, that framework would make sense again.

Strategy 5: Revisit Municipal Bonds
Last but not least, impending changes in income-tax rates should prompt higher-income earners to revisit whether municipals aren’t a better deal than taxable bonds. The 36% marginal income tax rate will kick in for single folks with income between $192,000 and $375,700; married couples filing jointly with incomes between $232,950 and $375,700 will also be taxed at that rate, according to the Tax Policy Center. Meanwhile, the 39.6% rate will apply to individuals and couples with incomes of more than $375,700. Municipal bonds were probably a good bet for those individuals and couples even before the tax hike, but they’ll be an even surer thing under a higher-tax regime. And while I generally prefer national muni funds versus ones that stick with a single state because of the former’s diversification benefits, the fact that tax rates in many states are apt to creep up may mean that single-state munis’ tax ben efits outweigh the forgone diversification benefit.

A version of this article appeared on Morningstar.com on Oct. 11, 2010.

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