Planning Amid Tax Uncertainty

Ben Franklin famously quipped that the only certainties in life were death and taxes. Of course, with the Bush tax cuts scheduled to sunset at the end of the year and the midterm elections capable of changing the balance of power on Capitol Hill, there is nothing certain about future tax policy. We can only surmise that taxes will, one way or another, likely increase at some point in the future.

If the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA)--the official names for the “Bush tax cuts”--sunset as originally legislated at the end of 2010, tax rates on ordinary income, long-term capital gains, and qualified dividends will revert to the higher, pre-2001 levels.

This table illustrates the differences in marginal tax rates after the sunset:

      Marginal Tax Rates         Marginal Tax Rates
                 for 2010                    as of January 2011
                     10%                                 15% (indexed and expanded)
                     25%                                 28%
                     28%                                 31%
                     33%                                 36%
                     35%                                 39.6%

Investors will also face higher capital gains tax rates. On January 1, 2011, the capital gains rate is scheduled to revert from the current maximum rate of 15% back to the 20% capital gain tax rate that was in effect prior to 2003.

Also, dividends which under the Bush tax cuts were taxed for the first time at the same low 15% rate as capital gains, will be reclassified and grouped with interest to be taxed at the higher rates levied on wages. In fact, unless Congress acts before the end of 2010, next year the top dividend rate will revert to 39.6% from 15%. That’s quite a leap.

What’s an investor to do? In anticipation of higher tax rates, if your portfolio includes appreciated assets, this year might be a good time to realize some gains at the maximum capital gains rate of 15%, rather than the 20% capital gains rate currently slated for 2011.

Investors in the 15% tax bracket or lower have a greater opportunity to save. For these investors, no gains are due on appreciated assets sold in 2010 if their gains are below a specified threshold. They would, however, be taxed at the 10% capital gains rate in 2011.

You should not, however, embark on a selling spree just to avoid what you think may be higher taxes down the road. Generally, you would want to have a purpose for the cash a sale would generate. For example, it may make sense to sell investments at gains this year if you have college tuition due next year for a son or daughter.  It also makes sense to sell individual, concentrated stock positions to adopt a more diversified and properly allocated portfolio.

If you are a business owner nearing your planned exit date, you may want to accelerate the sale of your business to avoid higher tax rates in the future.

And lastly, it is important to realize that the "wash sale rules" do not apply when selling an investment at a gain.  In other words, you can sell an investment today, record your gain, and buy it back immediately without waiting 30 days like you would when you harvest losses in your portfolio.