My F&M

The Chinese Curse

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As we begin our journey through 2012, the well known Chinese Curse – “May you live in interesting times” seems particularly timely.  One of the more “interesting” factors that could have significant impact on investment portfolios is the changing tax landscape.  No one can be confident about the future of tax laws, but the current favorable tax rates on capital gains and dividends are set to expire at the end of this year. Unless Congress passes some sort of extension, tax rates on dividends and capital gains revert back to those in effect before today’s rates were enacted early in the first term of the George W. Bush administration.  Capital gains will jump to 20% from today’s 15% and dividends (currently 15%) would lose any preference whatsoever and would be taxed as ordinary income at rates up to 39.6%. 

If that weren’t enough, the Health Care Surtax will impact investments in 2013.  The surtax itself is extremely complicated, so see your tax professional or planner for specifics, but essentially, interest, dividends, capital gains, rents, royalties and passive activity income will be charged this surtax which will impact married taxpayers filing jointly with taxable income above $140,000.  For those taxpayers, the investment income mentioned above will incur a surtax of 3.8%.  So for some, federal taxes on dividends may jump from 15% to 43.4% next year!

We have always counseled our clients that we would consider their individual accounts in aggregation for diversification purposes, putting different asset classes in the most tax efficient account.  Of course that has always meant that performance and risk should not be measured separately for personal taxable accounts and the various IRAs that clients may have set up.  This has allowed us to place investments expected to be highly taxed in tax sheltered accounts (where available) and lower taxed assets in a personal account.  The rule of thumb for as far back as we can remember was that stocks and growth vehicles should be held in taxable accounts and income vehicles in a tax sheltered account.  

In today’s “interesting” times, many stocks now yield more than bonds. Combined with the expected tax law changes the rule of thumb will have to be reconsidered.  We will continue to study the asset “location” question as events unfold and risk characteristics change, but don’t be surprised to see more stocks in your retirement account and high grade municipal bonds in personal taxable accounts.  Additionally, clients with low basis stock holdings may want to consider sales in 2012 to take advantage of current capital gains rates.

Given the political uncertainty of an election year, we don’t know if an extension of some sort could get passed before year end, but we do know that investment asset values represent the present value of expected future after-tax cash flows. Therefore, other variables remaining constant, when the current tax rates on dividends and capital gains go up, asset values decline simply as a function of math. More than ever, individual relationships with clients are essential to guide both of us in this interesting, but difficult time.