Tax Planning

Posted on April 17, 2013 by David Laidlaw

The absence of an established tax code makes planning extremely difficult. Income tax rates for different levels of earnings are subject to change even given the recent compromise legislation that passed over the New Year’s holiday. Rates are changing at both the Federal and State levels. California, for example, voted for tax rates exceeding 13% for the highest earners during the November voting.

At some point, deductions in the code may also be eliminated or capped as debated during the fiscal negotiations. These deductions include mortgage interest, state and local taxes, interest paid by municipal securities and charitable contributions. Reducing or eliminating deductions would increase taxable

income and push more filers into higher tax brackets allowing the government to increase its revenues.

Finally, although negotiated as part of the fiscal cliff bargain, the rates at which dividends and capital gains are taxed do not seem to be permanently settled.

The Estate tax framework appears more stable than any other area after the budget deal. Keeping the Unified Gift and Estate Tax Credit at $5.12 million represented a measure of continuity that was missing from the rest of the legislation. While the rate of tax increased to 40% from 35%, it appears that there is bipartisan agreement concerning the exemption level. This development eases the pressure on families with assets over $1 million that faced planning challenges if the rate fell to the level in existence in 2000.

All of these changes make long-term tax planning impossible. Planning for a contingency that never comes to pass could prove costly. For instance, imagine selling appreciated stocks in 2012 to take advantage of favorable capital gains and investing the proceeds in municipal securities only to discover that the income from these securities would be taxed fully as income. This twist would cause a substantial capital loss as the municipal bonds depreciated quickly as a result of the tax change.

Our philosophy during this period of change is to avoid making any radical moves that incur current taxes to benefit in the future since future paradigms are unknown. Investors will have the flexibility to deal with new tax regimes. For instance, if dividends are taxed as current income, then it will make sense to shift portfolios to lower dividend paying stocks. Companies will also respond by reducing their dividend rates and increasing strategies such as share buy-backs.

If capital gains tax rates are increased, investors will benefit from realizing lower levels of gains. At some point, the pendulum may swing back and future gains rates may be lower than the present.

If a grand bargain is reached on taxes so that the future structure becomes more stable, then it will make sense to engage in more long-term planning. Tax considerations should play an important role in investing; however, to quote Warrent Buffet’s Op-Ed piece which appeared in the New York Times in December … “[N]ever did anyone mention taxes as a reason to forgo an investment opportunity.”