Planning in a Volatile Tax Environment

As seen in the Concord Journal in September 2012
By Lee C. McGowan, CFP^®

As we approach the final stretch of 2012, there are several reasonable and looming questions on the minds of taxpayers and their advisors. What action will be taken with respect to the so-called Bush tax cuts of 2001 and 2003 and how will it affect me? What should I do regarding the Medicare surtax? How do we deal with the uncertain and ever-changing tax code?

Higher taxes in 2013 and beyond

In late 2010, the Bush tax cuts of 2001 and 2003, a broad group of tax provisions that lowered ordinary income tax rates, capital gains rates and dividend rates, initially scheduled to expire in 2010, were extended until December 31, 2012. Absent Congressional action, these Bush-era tax cuts will expire at the end of the year.These potential “tax increases” coupled with the Medicare surtax scheduled to take hold in 2013, have significant implications for taxpayers.

Time for predictions?

Regardless of Congressional action, there will be continued hot debate about the future of the tax code and who should pay higher income taxes (if anyone). While it’s simple to predict the level of intensity ofthis debate, itseems improbable to successfully predict the results. For this reason, it may be more prudent to adopt an “all-weather plan” that is suitable for various income tax environments.

Tax diversification

We’ve all heard that we shouldn’t put “all of our eggs in one basket.” In investment lingo, that means to diversify across various asset classes such as stocks and bonds in order to reduce the potential risk of loss and increase the potential for gain. If one believes in this strategy, then perhaps diversifying across taxable entities is also appropriate. The goal of “tax diversification” is to provide income streams and investment accounts that have differing tax characteristics (tax-deferred, tax-free, taxable).

Converting qualified retirement savings to Roth IRAs is one means to achieving this “tax diversification.”The Roth conversion received a great deal of press several years ago when income limitations were lifted for the strategy and taxpayers were allowed to spread the resulting conversion income over two years.Although taxpayers cannot spread the conversion income over two years at this point, having access to a tax-free stream of income in the future can be an advantage for many folks, particularly if they expect to be in a higher income tax bracket in the future.

In addition to Roth conversions, maximizing contributions to a tax-deferred retirement account (e.g., 401k, SEP-IRA) can help lower the current year tax burden and provide for tax diversification.

529 college savings plans

Another tax-favored account is the 529 college savings plan. Rather than holding funds aside for a child’s or grandchild’s education in a taxable account, making a gift to the 529 plan would provide for eventual tax-free withdrawals for qualified higher education expenses.There are both advantages and disadvantages of using the 529 plan (for potential financial aid and gifting-related reasons); it is recommended to use these plans with the overall financial picture in mind.

Tax-efficient investment strategy

The goal of a tax-efficient investment strategy is to allow investors to hold onto more of their investment earnings rather than paying it away in taxes. There are several strategies that improve the tax-efficiency of investment portfolios including holding low turnover investments in taxable accounts (e.g., an index fund or passively managed fund), buying taxable bonds in tax-deferred accounts (e.g., corporate bonds in an IRA) and harvesting capital losses for future capital gain offsets. We’ve all heard, “It’s not what you earn, it’s what you keep.”

While it’s certain that the remainder of 2012 will be filled with uncertainty, a thoughtful and well-crafted financial plan can help weather the volatile tax environment.