Remember those Venn diagrams you learned about in high school—the ones you used to show how two different sets of probabilities overlapped? They’ll come in handy for anyone trying to map out how the Nov. 6 elections will affect the taxes on their investments.
The permutations are many: if Republicans sweep the presidency and both houses of Congress, the tax policy that results will almost certainly be very different than if Obama is reelected and Democrats retain control of the Senate. And those permutations get crazier when you consider that each party has different ideas about how to deal with the so called “fiscal cliff”—that $600 billion package of automatic spending cuts and tax hikes that will take effect on Jan. 1 if Congress fails to act.
The takeaway for investors: Because of these variables, it’s not wise to make drastic changes to your portfolio right now. But there are some moves people should consider making to mitigate the impact of tax increases both potential and certain—because not everything hinges on the outcome of the election.
Here are four key areas of your financial life that you should consider before year end. Keep in mind the presidential candidates’ proposals are just that: anything the winner wants to make into law will have to pass Congress. Also, the sheer number of moving parts means it’s a good idea to consult your financial adviser or accountant before taking any action. You could make a move that helps one part of your portfolio and inadvertently hurt another in the process.
Capital Gains
What happens if we fall off the (fiscal) cliff : Taxes on long-term capital gains will increase from 15% to 20% for everyone above the 15% tax bracket—for which the annual income cut-off point for 2011 taxes is $34,500 for singles and $69,000 for couples. The capital-gains rate will rise from zero to 10% for those in the 15% bracket and below.
What the candidates propose : President Obama has proposed raising the capital gains rate to 20% only for individuals with incomes above $200,000 and married couples above $250,000, and leaving other rates unchanged. Romney would eliminate capital gains taxes for those making less than $200,000.
The Obamacare factor : Starting Jan. 1, high earners—those with gross incomes above $200,000 for an individual and $250,000 for a married couple filing jointly—will get hit with an additional, 3.8% tax on capital gains and investment income to fund Medicare improvements under the Affordable Care Act, otherwise known as Obamacare. This surtax is one of the few certainties on the tax front—it takes effect regardless of who wins the White House and what happens with the fiscal cliff.
Dividend Income
What happens if we fall off the cliff : Taxes on dividend income will rise from the current rate—either zero or 15%, depending on your tax bracket—to ordinary income rates for all taxpayers. That rate will be as high as 39.6 % for the top earners, up from the current 35%, as the top brackets are also set to rise. (Independent of the cliff, Obama has proposed raising the top two ordinary income rates to 36% and 39.6%, the levels they were at during the Clinton administration; Romney has proposed lowering all rates by 20%.)
What the candidates propose : Obama would keep the current 15% maximum rate on dividends for everyone except those in the top two brackets, who would pay 36% and 39.6%, respectively. Under his proposal, the 36% bracket would kick in for single filers with gross income above $200,000 and married couples filing jointly above $250,000, while the 39.6% rate would kick in above $390,050 for both single and married taxpayers. Romney would eliminate federal income tax on dividends for individuals with income under $200,000. Those above that level would pay 15%.
The Obamacare factor : Dividends are also subject to the 3.8% Medicare surtax for high earners.
Itemized Deductions
What happens if we fall off the cliff : Itemized deductions, of course, include various qualified expenses on mortgage interest, charitable contributions and other categories that can help lower your gross adjusted income for tax purposes. Only 30% of taxpayers itemize their returns, according to the Tax Policy Center, but those who do are overwhelmingly higher income. If the fiscal cliff is triggered, taxpayers with income above a certain threshold—estimated by the tax center to be $174,450 for individuals in 2013—will see reductions in the value of their deductions. Under the maximum “phase out,” 80% of a taxpayer’s itemized deductions would become ineligible next year. In other words, someone who could claim $100,000 in deductions in 2012 may lose as much as $80,000 of those deductions in 2013, depending on the person’s adjusted gross income.
What the candidates propose : Obama has proposed raising the income threshold for the phase out to $200,000 for single taxpayers and $250,000 for couples. Romney, on the other hand, has proposed capping itemized deductions across the board at a fixed level that hasn’t yet been determined.
Retirement Accounts
No provisions relating to retirement accounts are affected by the fiscal cliff, nor has either candidate proposed any changes to IRAs and 401(k)s. But that doesn’t mean you should necessarily stand pat, advisers say. Since ordinary income tax rates have a good chance of rising, now’s a good time for higher earners to consider converting their traditional IRA to a Roth. If you convert to a Roth before the end of the year, you’ll likely pay less than you would next year. That’s because Roth IRA contributions are taxed at ordinary income rates on the way in but not the way out; by contrast, contributions to traditional IRAs get taxed only at withdrawal.
For those sitting on capital gains, one particularly savvy move would involve selling an appreciated asset before year-end, and funding the Roth conversion with the proceeds. Otherwise, those gains will be subject to the 3.8% Medicare surtax come Jan. 1. One caveat: Converting to a Roth makes less sense if you anticipate earning significantly less income next year—say, due to an impending retirement—which would automatically bump you into a lower bracket anyway.
Source: Elizabeth O'Brien, MarketWatch
The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.
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