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HOW INVESTORS CAN ADJUST TO EXPIRING TAX PROVISIONS

posted 11/21/10 | Wealth Management

By:  Andy Bryan, Vice President - Strategic Advisor
       Enterprise Trust Company

A set of tax provisions that are scheduled to expire at the end of this year will change the tax landscape for many investors who will need advice on how to adjust.

Expiring tax provisions, or “sunsets,” have long been a feature of the Tax Code, but they usually involve relatively minor provisions. The Economic Growth and Tax Relief Reconciliation Act of 2001, also known as EGTRRA, and the Jobs and Growth Tax Relief Reconciliation Act of 2003, known as JGTRRA, depart dramatically from historical patterns. Collectively, they reduced taxes on ordinary income, long-term capital gains, and qualified dividends; mitigated marriage penalties; expanded the child tax credit and the child and dependant dependent care tax credit; and phased out limitations on itemized deductions and the phase-out of personal exemptions.

With the sunset of these provisions at the end of this year, individual income tax rates in 2011 will revert to higher, pre-2001 levels.

Here are a few suggestions for how investors can adjust to a new tax landscape:

• Catch the early bird special. In anticipation of higher tax rates, this year may be a good time to take some gains off the table at the maximum capital gains rate of 15 percent rather then the 20 percent currently slated for 2011. Investors may also consider accelerating the sale of a home or business to avoid higher tax rates down the road. Unlike tax loss harvesting to book capital losses at the end of the year, there is no wash sale rule that precludes them from buying a security right back when they sell it and register a gain.
• Diversify retirement savings from a tax standpoint. Having taxable and non-taxable pots to draw from makes sense in an uncertain tax environment. Conversion of a traditional IRA to a Roth IRA is a good example of this type of diversification. If the nation is indeed entering a long period of rising income tax rates, paying a conversion tax bill may seem like a bargain in retrospect.
• Use fraud losses. Because a Roth conversion is an ordinary income taxable event, taxes due can be offset by major losses due to fraud which are booked as an ordinary income loss as opposed to a capital loss. It’s also possible to go back a few years for loss carry forwards to add to write-offs of ordinary income. When you go back and zero-out tax liability, you save that 10-15 percent on a good chunk of dollars.
• Rethink some standard financial planning advice. High level executives are typically encouraged to defer some salary, but if you have the flexibility, receiving ordinary income this year instead of in a later year when tax rates may be higher could prove beneficial. Executives might decide to exercise their non-qualified stock options earlier. From a charitable contribution standpoint you may be better off spreading out a large gift or defer it into the future to gain a greater tax deduction. 
• Understand your father’s dividends will cost you more.  Currently, the maximum tax rate on qualified dividends is 15 percent, but that will revert to regular income tax rates in 2011. A change of this magnitude will certainly make dividend paying stocks less attractive in a retirement income stream. Income tax exempt and tax deferred vehicles like municipal bonds, tax-deferred annuities, life insurance, and non-qualified deferred compensation do not count as investment income; investments in these should become more favorable relative to investments producing income subject to tax.

Bottom line? The Tax Code is in a state of flux. With federal estate tax already expired and the potential for a reversion to the 55 percent tax for estates valued at more than $1 million, portfolios have to be re-examined in light of the anticipated sunsets. 

Of course Congress could reverse course and pass an extension to the Bush-era tax cuts to hold the current rates steady, but it’s a gamble to assume they will be made permanent or comprehensive given our current level of national debt

It’s important to stay in close touch with your financial advisor so you can prepare for the major changes and take advantage of any emerging opportunities.

Please note that this information is not intended to be tax advice.  Be sure to consult with your tax advisor on any tax related matters.

Andy is a Vice President and Strategic Advisor for Enterprise Trust Company.  He has over ten years of experience helping clients create and grow their wealth.  You can contact him directly at 314.512.7266 or abryan@enterprisebank.com.