A year and a half into the Obama administration, the federal budget deficit is soaring. Spending has swelled as the government expended funds to support financial institutions, stimulate the economy and provide benefits to out-of-work families. Meanwhile, the recession brought a precipitous drop in federal tax revenues.
To address the mounting deficit, President Obama has asked Congress to approve a tax increase on affluent families. The president is proposing permitting the Bush tax cuts to expire on schedule at the end of 2010, but only for families with taxable income over $250,000 (individuals with income over $200,000). Under this plan, the top tax rate on ordinary income will rise from 35 percent to 39.6 percent, the top capital gains rate will rise from 15 percent to 20 percent, and the top tax rate on dividends will rise from 15 percent to 20 percent.
Some members of the House Ways and Means Committee have indicated that the dividend tax rate should rise all the way back up to 39.6 percent, taxing dividends as ordinary income as they were during the Clinton years.
This year, Congress enacted a sweeping national health care program, the largest social program in decades. To finance the program, Congress approved an additional 0.9 percent tax on employment compensation in excess of $250,000 ($200,000 in the case of individual taxpayers) and an additional 3.8 percent tax on taxable investment income earned by families with adjusted gross income above $250,000 ($200,000 in the case of individual taxpayers).
The new taxes under health care reform are scheduled to take effect at the beginning of 2013, raising the top tax rate on ordinary income at that time to almost 44 percent and the top tax rate on capital gains to almost 24 percent — an increase in the ordinary income tax rate of almost 25 percent, and in the capital gains tax rate of almost 60 percent.
Furthermore, it is likely that additional tax revenues will be needed to finance mounting federal expenditures. The deficit was projected to grow significantly, even before incurring the additional costs of economic stimulus, financial crisis remediation, and health care reform. Social Security and Medicare outlays are projected to increase dramatically in coming years to meet the needs of aging baby boomers. Interest payable on the inflated national debt also is projected to grow significantly. Meeting these expenditures could require more new taxes, the bulk of which likely would be borne by higher-income families.
By taking action this year, investors may be able to blunt some of the effects of future tax increases. Some options to do so are reviewed below. Investors should not necessarily undertake any or all of these steps now. In many cases, it will make sense to consider them as we learn more about the future course of tax legislation.
1. Sell assets to take advantage of existing capital gains rates.
Investors with long term gains in their assets should consider selling and recognizing the gain before the top applicable tax rate rises from 15 percent to 20 percent. Selling before a tax hike locks in gain and can produce a greater after-tax yield. For instance, consider an investor who purchased stock in late 2008 at $5,000 per share. Suppose that stock is now worth $15,000. If the investor sells in 2010 at a 15 percent capital gains rate, the sale will yield $13,500 after tax. To yield the same amount after a 20 percent tax rate, the stock value would have to increase to $15,625, an additional increase of over 15 percent.
Investors likely will be able to obtain the lower capital gains tax rate by selling at any time this year. But they should keep an eye on the tax bill as it moves through Congress, as Congress conceivably could move up the effective date to avoid a year-end sell-off. If that were to happen, investors likely would have sufficient notice to sell assets traded on an established exchange. But they might not have time to sell non-marketable assets such as real estate or a business. Investors selling those types of assets might want to consider a sale earlier in the year rather than later.
By selling this year, investors can lock in gains realized during the run-up that occurred in 2009. They then can redeploy the proceeds to investments that offer stable growth and downside protection, a strategy that might be prudent in uncertain times. One such investment is a variable annuity, which offers tax deferral as well as downside protection — another important benefit as tax rates rise. Other investors who wish to keep their investments can sell a security, recognize the gain and immediately repurchase that security to reestablish the position.
The "wash sale" rule, which requires investors to wait thirty days before repurchase, applies only to recognition of losses, not gains.
2. Receive ordinary income currently rather than in a later year when tax rates may be higher.
With ordinary income rates expected to rise, investors might act to receive additional taxable income currently rather than in later years. For instance, executives could consider exercising non-qualified stock options this year so that the resulting income would be taxed at prevailing rates.
3. Defer discretionary deductible payments (such as charitable contributions) to later years when they may be worth more due to higher tax rates.
The tax benefit of a deductible expenditure increases as tax rates increase. With a tax increase expected, it may be worthwhile to defer deductible payments until the higher rate takes effect. For instance, at the current top federal tax rate, a charitable contribution of $100 yields a benefit of $35. If the federal rate rises to 40 percent, making that contribution next year would save $40 in taxes.
Thus, investors considering making large charitable contributions might consider deferring them until the beginning of 2011.
4. Give increased consideration to municipal bond investments.
As tax rates increase, demand for municipal bonds increases, because more people wish to reduce the tax they pay. Similarly, as tax rates rise, the effective interest rate on municipal bonds increases. For instance, a municipal bond paying 3 percent interest pays a tax-equivalent yield of 4.6 percent in a 35 percent tax rate environment. But if tax rates rise to 40 percent, the tax-equivalent yield on the same bond rises to 5 percent. In short, all other things being equal, rising tax rates can signal rising municipal bond values.
