The Great Tax Dodge is under way already.
The how and which of tax increases are still unclear. But there is no question about the if: Higher taxes are coming.
Fearing that tax–code changes could slam fortunes large and small, investors aren't sitting still. In the first three weeks of February, they poured twice as much money into tax–free municipal–bond funds as into all foreign–equity funds combined. At Fidelity Investments and Charles Schwab Corp., account holders are converting taxable Individual Retirement Accounts into tax–free Roth IRAs at quadruple the pace of last year. And more executives are passing on deferred compensation in favor of cash today, tax experts say.
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"I'm having no trouble convincing my clients their taxes are going up," says Dean Barber, a financial planner near Kansas City, Mo. "They're scared already."
The list of potential rises is long and growing. The likeliest include increases in income and capital–gain rates. Most ominous: lawmakers may breach the wall between wages and investment income by applying Social Security or Medicare taxes to dividends, interest, capital gains, and annuities.
We have been down this road before. Two decades ago, when U.S. debt and deficit levels were on an unsustainable path, market pressures forced the governments under George H.W. Bush and Bill Clinton to cut spending, impose budget constraints, and raise taxes. Now, as then, legislation is notoriously unpredictable. The only near–certainty is that lawmakers won't raise taxes for 2010—unlike cash–strapped states that already have boosted rates. So investors have some time to prepare for federal changes.
Experts warn not to let panic spawn stupid moves. When marginal tax rates reached 70% in the 1970s, investors were lured onto tax–shelter shoals later littered with empty railcars, idle barges and see–through buildings. "A lot of them were bad deals that wound up costing more than paying the taxes would have," recalls independent tax expert Robert Willens.
Given the certainty—if not the timing—of tax increases, here are some cool–headed moves to consider now.
Roth IRA Conversions
This is the first year all taxpayers have been allowed to convert regular IRAs to Roth IRAs regardless of income. Until 2010, those who made more than $100,000 were out of luck. In regular IRAs, contributions come from pretax dollars and grow tax–free. But payouts are both fully taxable and mandatory after a certain age.
Roth accounts are different: Contributions come from after–tax dollars, and all growth and payouts are tax–free. Also, the owner doesn't have to take mandatory payouts. That means a Roth IRA can offer an escape hatch to those worried their tax rates will be higher in the future.
The drawback is that full income taxes are owed on the conversion. Anyone converting in 2010 can defer those taxes into 2011 and 2012. But many are planning to take the hit this year to lock in the 2010 rate.
Costs associated with Roth IRAs are minimal compared with hiring experts to develop conventional tax shelters. They can easily be customized: Accounts, for example, may be converted piecemeal over several years to avoid tax–bracket leap.
Better yet, conversions allow for do–overs: owners may divide an IRA into smaller pieces before converting and then reverse switches as long as 22 months later, if the asset value has dipped. But other traps bedevil profitable Roth conversions (see box).
Roth IRA Tax Traps
Investors are rushing to convert traditional IRAs to Roth IRAs. But that can trigger painful financial consequences. Here is how to trim costs:
Take your traditional IRA distribution first. IRA owners 70½ and older who convert must still take the required annual distribution. Those who fail to do so may face a 6% excise tax on the entire amount they should have withdrawn.
Calculate the tax impact. Since converting inflates your taxable income, you may become ineligible for certain tax benefits, such as credits and deductions. To keep your income below these thresholds, convert just a portion of your IRA.
Figure the effect on Social Security. A Roth conversion may push your adjusted gross income above the thresholds at which Social Security recipients must pay tax on a portion of their benefits.
Calculate the Medicare consequences. Once a Medicare recipient's modified adjusted gross income exceeds $85,000 annually, higher Part B premiums kick in. For couples, this can cost up to an additional $5,835 a year.
Don't convert company stock from a 401(k). Put it in a taxable account. Otherwise, You may lose a valuable tax break, "net unrealized appreciation," which allows you to pay the lower long-term capital-gains tax rate on the appreciation when you sell the stock.
Fill out a new beneficiary designation form. Roth accounts typically require their own beneficiary designation form. Accounts that lack a beneficiary must be liquidated within five years of the owner's death. That limits heirs' ability to stretch tax-free withdrawals.
Make sure the money got there. Custodians have been known to transfer money to the wrong account. Ask your custodian to move the money via a direct "trustee-to-trustee" transfer. If you discover an error, you have 60 days from the date the money left your IRA to get it into a Roth.
Executives are scrutinizing pay and benefits to bring income into 2010. Withdrawing pay already deferred is trickier due to post–Enron rules designed to prevent executives from cashing in ahead of disaster.
Many are revisiting stock options, both incentive stock options (which receive highly favorable tax treatment) and nonqualified options, which have fewer tax benefits but are far more common.
To reap the full tax benefits of either type, owners must hold them a year after exercise. Those who haven't started the process won't be able to finish by the end of 2010. But it may make sense to start the clock running, especially for those with nonqualified options. Income and FICA taxes are due on the entire gain between the grant price and the exercise price of these options, and these levies may rise next year. Those short of cash can often do a "cashless" exercise by selling some shares immediately to pay the tax cost of holding onto others.
Restricted stock has become popular. None of the stock's value is taxable until it vests several years after the grant date. But within 30 days of that date, employees may make an "83(b) election" to pay ordinary income and FICA tax on the grant price, which converts future growth to capital gains. That helps if taxes rise. But if the stock is forfeited or loses value, income and FICA taxes that have been paid can't be recovered.
If the administration's proposals pass, the 2011 tax rate on gains will rise by a third, more than any other. If Medicare taxes are added as well, it will increase by half. Tax strategist Robert Gordon of Twenty–First Securities Corp. in New York City says most of his clients worried by this increase have already sold.
The good news is that current proposals don't raise taxes on "qualified dividends"—most of those on stocks held longer than two months. Until 2003, dividends were taxed like interest, at higher ordinary income rates.
Mr. Willens recommends that owners of closely–held C corporations and Subchapter S corporations that converted from C status consider accelerating dividends into this year. The alternative is to leave them in the business until it is sold.
Those who are receiving income from installment sales may want to offer the buyer a discount to pull payments into this year. Or it might make sense to sell the note to a third party.
During 2008's flight to quality, some muni yields were twice as high as Treasury yields, and many long–term muni funds returned a sizable 10% or better for 2009. Last year, investors put more money into muni funds, $69 billion, than in the previous 10 years combined. Some investors were merely fleeing dismal yields on money–market funds.
Now some yields are closer to historic norms of about 80% to 90% of Treasury yields. Demand for munis is likely to grow even more with higher taxes, and investors should remember that rising interest rates can hit munis hard because they often have long maturities. Supply is under pressure as well, as issuers turn to cheaper (for them) Build America Bonds, which are both taxable and federally subsidized.
Credit quality isn't the concern that the sorry state of some local economies might suggest. "There are fifty states and thousands of bond–issuing authorities; they aren't all going to go bankrupt," says T. Rowe Price Group Inc. municipal–bonds overseer Hugh McGuirk. Historically, the rate of recovery in munis has been higher than with other types of bonds. T. Rowe, like Fidelity, Vanguard Group and several others, does its own credit analysis.
Diversification is the best hedge against risk. Kenneth Woods, the founder of Asset Preservation Advisors of Atlanta, believes the minimum for a portfolio of individual bonds should be $1 million and likes 3% or less of the total in any one issue. Investors buying bonds outright also need a trustworthy broker to minimize spreads. But individual investors rarely can buy munis commission–free as they can U.S. government bonds at TreasuryDirect.
Muni funds are typically well–diversified, but investors should favor those with low expenses (under the average of 0.6% for no–load muni funds) and compare before– and after–tax returns listed in a fund's prospectus. Some muni funds raise returns by trading, and that can that give rise to taxable capital gains 30% or more of the total.
Rising tax rates can make charitable deductions more valuable. The administration has proposed to limit the value of all write–offs for upper–bracket taxpayers to 28% from the current top rate of 35%. But this measure faces stiff head winds from powerful lobbies. Assuming this draconian measure stalls, many taxpayers may want to delay large gifts either of cash or appreciated property until the time, which is certainly coming, when tax rates rise.
Write to Laura Saunders at firstname.lastname@example.org