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Make Changes or Stand Pat?
By Christine Benz | Morningstar – Sun, Jul 29, 2012 7:00 AM EDT
A slew of Bush-era tax laws are set to expire at the end of 2012, affecting the tax rates on everything from dividends to capital gains to ordinary income and estates. But a lot remains unsettled, too, particularly given that we’re in the midst of an election year and the direction of tax rates remains a key bone of contention.
Posting in the Portfolio Design/Management forum of Morningstar.com’s Discuss boards, I recently asked Morningstar.com readers whether they were taking action with their portfolios to mitigate the threat of higher taxes down the line. Readers were quick to share their strategies, with Roth conversions, preemptive capital gains harvesting, and proper asset location among the most frequently discussed tactics. But other readers aren’t so sure it’s wise to act preemptively, given that the future of tax rates might not be settled until later in the year…
‘We Want to Be Ahead of the Crowd’
One strategy that received repeat mentions from Morningstar.com users was the idea of selling highly appreciated securities in 2012, to take advantage of today’s relative low capital gains tax rates. Capital gains rates are poised to go from 15% to 20% for most investors in 2013.
Outlining the strategy was JBP57, who wrote, “Come December we will be selling and repurchasing all taxable accounts that have gains to get the step-up in basis and pay the tax on the gains at this year’s tax rate.”
Dragonpat will be starting to sell winners even earlier: “Starting in October/November any stock or mutual fund that has a least a 20% gain on it, I am going to sell and possibly rebuy at a higher basis to minimize future taxes.”
Yet several posters warned that this strategy might not be the slam-dunk it seems to be, particularly if sellers are rushing the exits at the same time.
Big Red wrote, “I expect funds and individuals to harvest gains and realize corresponding loses this year, putting significant selling pressure on the markets resulting in falling prices starting mid-October. We want to be ahead of the crowd, harvesting gains and taking loses soon in the hope of repurchasing many of the same stocks at an equal or lower cost basis in November and December. We are willing to risk having to repurchase at higher prices because we do not intend to withdraw any monies for 12-15 years.”
Edmund_Dantes, in fact, thinks that tax-loss selling could create buying opportunities for opportunistic investors. “My principal consideration in this regard is to be cognizant of tax-loss selling deadlines for institutions (Oct. 31) and the typical date when the bulk of individual selling ends (Dec. 15). I suspect institutions especially will be keen on realizing taxable gains this year, at the lower rates. I suspect this to create greater-than-normal selling pressure and am consciously keeping my cash balances higher than normal–both to preserve capital and to participate should a buying opportunity occur.”
FidlStix is also licking his chops. “My ‘financial fantasy’ right now is that everyone will jump in to sell taxable securities at end of year to harvest gains/losses and pay taxes at present tax rates. The resultant sell-off will make shares plunge to attractive prices. Then I, the proverbial tiger crouching in the bushes, will pounce on as many of those wounded shares as my stomach can hold. Dream on.”
Bnorthrop, meanwhile, reckons that his tax losses might be more valuable than ever in a high-tax regime; his goal is to save them for when he really needs them. “All I’m doing is trying to prolong my tax loss carryforward from 2008-09 by annual tax-loss harvesting. The carryforward may be more valuable in the future.”
Rule 72 says he’s not inclined to sell preemptively, in part because he already has a strategy for reducing the tax hit on his portfolio’s biggest gainers. “For the foreseeable future we may never need the equity money in the taxable account and the kids would get the stepped-up basis upon our death. Thus, no tax on that gain anyway.”
‘Focus on Known Bets’
For other posters, the planned tax increases provide yet another reason to max out tax-advantaged vehicles and make sure they’ve optimized their asset location for maximum tax efficiency.
JavaJoe is taking advantage of all the tax-sheltered options he can think of and pulling money from taxable accounts. “As a young accumulator, our approach has been to maximize tax-advantaged accounts and focus on ‘known bets.’ In part because of upcoming tax law, but also due to overall market valuations, we’ve tried to drain our taxable investment account over the past few years by aggressively funding two 529s and two Roths, maxing out a SEP-IRA, contributing to a 401(k), and then donating our most appreciated securities or tax lots in our taxable account into a donor-advised fund for future charitable giving. And, although controversial, we decided to take some proceeds from our taxable account and ‘lock in’ the interest rate savings and tax treatment by paying off our home mortgage.”
Managing taxable portfolios to limit the tax collector’s cut of ongoing returns was also the subject of discussion.
What to do with dividend payers, where the tax rate is set to jump from 15% for most investors to the ordinary income rate, was top-of-mind for Big Red. This poster shared a multipart strategy for dealing with the threat. “We intend to concentrate our low-dividend growth stocks in taxable accounts. This will allow us to manage our tax liability over time by offsetting gains with corresponding losses (assuming the tax code will still allow offsets). We also plan to move dividend stocks into our IRAs and at least delay the impact of our federal tax rate increasing from 15% to nearly 45% which will hurt more than a little. Finally, we will probably increase our proportion of tax-exempt muni-bonds. With state and local taxes on dividends a little over 50%, some munis may be attractive even at these low rates.”
Counterpoint is similarly concerned about limiting taxes on his taxable portfolio, though he’s cautious on municipal bonds given their recent runup. “I already have a healthy exposure to muni bonds and am concerned about overvaluation in this sector. There are also grumblings that munis may not remain tax exempt for upper income investors forever.”
Instead, this investor has been tinkering with the equity portion of his taxable account to make it more tax-efficient. “One change I started making last year was building a portfolio of individual large cap blue-chip stocks with low (less than 2.5% yield) or no dividend. First, I view this subset of blue-chip stocks as generally being better valued than higher-yielding blue chips. Second, these stocks will (hopefully) have more of a capital gains and less of an income component so I can minimize and better manage my future income recognition. Finally, individual stocks will give me more flexibility in netting gains and losses to reduce capital gains in the event I decide to liquidate some equity positions in the future. For other equities, I remain substantially invested in low turnover equity vehicles like SPDR S&P 500(SPY) and avoiding, for the most part, funds that have a lot of turnover and distribute a substantial amount of capital gains most years. One final thing I may have mentioned before (sorry if I did) is investing in Kinder Morgan Management(KMR), one of the Kinder Morgan entities. This particular entity pays its dividends as stock, and these stock dividends are not taxable until the stock is sold. I wish there were many more investments like this.”
Mr. Ed will also help his in-laws revisit their taxable portfolio if in fact the dividend tax rate jumps up. “I will investigate the possible effects of the changes on my in-laws’ taxes. They are not wealthy, and estate tax changes will not affect them. However, since they are in 15% bracket, with significant dividends, it is time to talk with their primary investment company about portfolio structure and selling.”
‘I’ll Just Have to Be Long-Lived to Make This Work’
Another frequently mentioned strategy was to convert traditional IRA assets to Roth, which would have multiple potential benefits in a higher-tax clime. First, the taxes due upon conversion would be based on 2012’s relatively low rates. Second, Roth assets will be even more valuable if income tax rates rise in the future because Roth withdrawals are tax-free. Finally, Roth assets aren’t subject to the new Medicare surtax going into effect in 2013.
Converting is top-of-mind for Dragonpat, who wrote, “I am going to turn 59 1/2 in September. I am going to convert as much of my 401(k) to a Roth as I can with tax money that I am going to harvest out of a stock option that I have saved for this purpose and some stock from the employee stock purchase plan.”
Jomil has been on top of this strategy for some time, writing, “I converted [my] remaining traditional IRA shares to Roth in 2010 with the tax paid over two years. After retiring three years ago, I rolled over various deferred compensation retirement accounts into traditional and then Roth IRAs.”
Chief K has been converting traditional IRA assets to Roth, and will be doing some more this year, with the expectation that future tax rates will be higher than they are today. “I’d considered not making any more Roth conversions this year, especially since I’m 67 and would have to count on a long life to make the conversion pay off. However, I’ve concluded that our national debt will force us to accept both higher tax rates as well as lower government spending. Hence, I will be converting some of my company’s Simple IRA Plan this year to my Roth at Vanguard. I guess I’ll just have to be long-lived to make this work.
Many of Dragonpat’s planned tax-related maneuvers aim to reduce her susceptibility to the new Medicare surtax. She wrote, “I am going to discontinue Roth 401(k) contributions Dec. 31, 2012 and only make regular 401(k) contributions, to lower my adjusted gross income to get as little of our income taxed by the new 3.8% Medicare tax.” (The surtax kicks in on whichever amount is less: net investment income or adjusted gross income over certain thresholds.)
Dragonpat went on, “Similarly I have been moving my mutual funds to my Roth ($6,000) per year out of my taxable portfolio to avoid the 3.8% Medicare tax on distributions. My taxable portfolio will be 100% exchange-traded funds and individual stock so that capital losses and gains can be harvested more easily using limit orders.”
Susanirs, like many savvy investors, has the estate tax on her radar as 2012 winds down. On her extensive tax-related to-do list? “Relook at our wills for estate planning since the [amount that skirts estate tax] could be dropped to $1 million.” Artsdoc agrees: “I am definitely making an appointment with my estate attorney for December.”
‘I’m Not Changing a Darned Thing’
Yet even as some readers planned to be actively maneuvering in the second half of the year, others said that they’re standing pat.
ColonelDan is happy with his portfolio from a tax standpoint; no further tinkering is needed. “No changes: IRAs will remain as is and taxable side will stay in intermediate-term munis.”
Similarly, DrBobb isn’t putting the tax cart before the horse. “I’m retired and I don’t plan to make changes to our portfolio based on possible tax law changes. It is impossible to predict how the tax law might change. Much of our portfolio is in muni bonds and dividend-paying stocks. The munis are not likely to be affected. And we won’t sell the stocks because we need the dividend income.”
Vince5280, too, aims to stay focused on the investment merit of his income-heavy portfolio rather than the tax implications of some of its holdings. “I’m concerned about the tax changes, but I feel that it is more prudent to continue focusing on the best long-term investment versus the impact of taxes.”
JHASheville also sees few reasons to begin tweaking.”No question about it. I’m staying put. I like where the portfolio is and although I’m not fond of taxes a little more won’t hurt when it comes right down to it. Couldn’t tweak it too much anyhow because the only side that could us a snip here or there is in our taxable accounts and no real losers to harvest from at this time.”
Other posters noted that they weren’t making preemptive portfolio alterations, believing that Congress could make significant changes before it’s all over. Cliff offered an analogy that will resonate with long-suffering fans of Chicago’s National League ball club. “I’m not changing a darned thing in advance of what may or may not happen. Doing so, for me, would be about the equivalent of booking airline and hotel reservations now to attend the celebration party when the Cubs win the World Series this year. Things might not work out as anticipated.”
Skipperchg didn’t mince words: “Anyone making major portfolio changes on the basis of what Congress (particularly this one) might or might not do with taxes is out of their minds.”
