Tax issues could alter investing

Investing is challenging enough with all the usual risks and dangers.

Add in the uncertainty over income taxes, and things get even dicier.

Yet that's where investors find themselves as Washington continues to debate tax policy.

The Bush-era laws that ushered in lower tax rates on income, dividends and capital gains are set to expire at the end of 2010.

The White House wants to extend the tax breaks for all but the wealthiest 2 percent or so of Americans, but not all Democrat lawmakers are on board. Some side with Republicans in favoring stable, if not lower, tax rates. Throw in the gridlock and distractions of an election year, and it's hard to make solid predictions.

"I'm expecting the tax cuts are going to expire for everybody," said Mark Rosenfeld, a certified public accountant and personal financial specialist in Scottsdale. "That's the way the law is written."

Assuming this issue isn't resolved soon, here are some investment tax issues to ponder:

• Locking in profits.

Top tax rates on long-term capital gains are on tap to rise from 15 percent to 20 percent next year. That could make it wise to lock in profits at today's rates by selling soon.

"I'd consider taking my gains (this year)," Rosenfeld said.

Jason Lattin, an investment principal at Lowry Hill in Scottsdale agreed, although he cautions that tax considerations should be secondary to the investment reasons for holding, or unloading, assets.

• Skirting dividends.

Taxes on dividends, now capped at 15 percent, could rise as high as 39.6 percent for high earners.

This could make it smart to shift high-yield stocks and funds into sheltered accounts or avoid dividends entirely.

But while demand could drop a bit for dividend-paying stocks, Lattin doesn't foresee a big shift. Many of these firms are stable, he said, and their payouts appeal to an aging investor base.

Jack Ablin, chief investment officer at Harris Private Bank in Chicago, predicted dividend stocks could prove even more popular in a low-growth economy and if market turmoil persists.

"One of the most certain attributes of equity investing is dividends," he wrote recently. "Notwithstanding the prospect of higher tax rates on dividend income, dividend yields will likely become a greater share of market return."

• Using sheltered plans.

Various retirement accounts such as IRAs and 401(k)-style plans will still be around even if the Bush-era breaks lapse. As such, it might pay to shift more new investment dollars into these areas.

Rosenfeld especially favors Roth IRAs, from which withdrawals can be taken tax-free in retirement. He's less enthusiastic about traditional IRAs and 401(k)-style plans, since they defer taxes only.

But he suggests investing in 401(k) plans at least to qualify for employer matching funds.

• Seeking tax efficiency.

Various other investments strive to minimize the tax bite. Tax-managed mutual funds, for example, do this by reducing taxable payouts to shareholders, harvesting losses for use in offsetting capital gains, avoiding tax-triggering trades and skirting taxable bonds and dividend-paying stocks. Unlike IRAs and 401(k) plans, the funds can be bought by anyone, without income- or job-based eligibility. Also, unlike retirement accounts, profits on these funds can qualify as long-term capital gains, at preferential rates.

• Staying conservative.

If tax rates rise, municipal bonds and muni-bond funds could gain attention. Their yields generally are tax-free, giving them an edge over corporate and government bonds.

"In this environment, muni bonds are becoming increasingly attractive," Lattin said.

Darren Wright of Wright Wealth Management in Phoenix offered another suggestion: whole life insurance. These policies feature such benefits as tax-deferred growth and proceeds at death that skirt income taxes. Wright considers whole life most suitable for conservative, long-term investors who need insurance. Other insurance products, including variable annuities, also offer tax advantages.

• Converting IRAs.

If you're really worried about taxes, it might pay to convert some or all of your traditional IRAs into tax-free Roths. You'll likely need to pay taxes on most if not all the assets you transfer, and it's smart to use non-IRA money to do so. But if you convert in 2010 only, you may spread the bill over the next two tax years, 2011 and 2012.

Converting comes with drawbacks - namely, the need to pay taxes up front, perhaps decades earlier than they would be due. But Rosenfeld sees merit for many people, partly because the bill can be spread out or paid at the low rates in effect now.

Plus, you can change your mind. Uncle Sam will let you to cancel or "recharacterize" a conversion. You have until Oct. 15, 2011, to void a conversion done this year.

You may split a regular IRA into several Roths and undo just some conversions. For example, you could let stand conversions on accounts that appreciate while canceling those where values shrink.

"You can cherry-pick the accounts you want to recharacterize," Rosenfeld said.

by Russ Wiles The Arizona Republic Aug. 8, 2010 12:00 AM


Tax issues could alter investing