Even if regular investment planning is already part of your routine, you might want to pay special attention this year. Why? Because beginning in 2011, significant changes in the federal tax code are scheduled to take effect, which could substantially alter the taxation of your portfolio. That could in turn affect your investment strategy. That’s why it’s even more important than usual this year to think about whether your portfolio needs fine-tuning.
If you fall into any of the following categories, you’ll want to pay special attention to your investments in the coming months to make sure you understand how the changes might affect you. Now more than ever, it makes sense to consider taxes as a factor when making investing decisions.
You own investments that have appreciated substantially in value
You’ll want to take into account new, higher rates that are effective in 2011. For the 2011 tax year, the maximum tax rate on long-term capital gains is increasing to 20%, while investors in the lowest tax bracket will owe 10% (special, slightly lower rates for investments held for more than five years will apply beginning in 2011). That’s an increase from the 2010 maximum rate of 15% and zero for the two lowest tax brackets. If you’re considering selling assets that have increased in value, the higher rates could affect whether and when you decide to sell. That can be especially true if a particular security has grown enough to represent a substantial portion of your portfolio.
You’ve converted a traditional IRA to a Roth IRA
If you converted a traditional IRA to a Roth IRA in 2010, the taxable ordinary income from the conversion would normally be reported on your 2010 return. However, a 2010 conversion also gives you another option: you can choose to report half the income that results from the conversion on your 2011 tax return, and the other half on your 2012 tax return. Your decision could make a difference in when it makes sense to book capital gains.
For example, if you’ve decided to postpone paying taxes on the income from a Roth conversion, you’ll owe taxes on half of that income in 2011 and the second half in 2012. That tax liability on top of any capital gains tax on the sale of other taxable assets could mean a sizable overall tax liability. If that’s the case, you may want to consider adjusting the timing of any sale based on when you anticipate incurring your Roth conversion tax liability.
However, remember that tax considerations shouldn’t be the only factor in your decision. Any tax advantage could disappear quickly if the value of a stock drops substantially before you plan to sell it.
You plan to harvest losses or rebalance your portfolio
Federal income tax brackets are scheduled to change substantially in 2011 (see sidebar). If
harvesting losses to offset realized capital gains is part of your strategy to minimize taxes, consider
the timing of your sale. If you anticipate higher taxes in the future, a tax loss could be more valuable at the higher rate. Also, if you rebalance your portfolio regularly at the end of the year, and it looks as though that rebalancing will require the sale of some of your appreciated assets, think about your current and future tax brackets and whether postponing a sale is warranted.
Again, though tax considerations shouldn’t be the sole factor in a decision to buy or sell, they shouldn’t be ignored, either–especially this year
Dividends represent a substantial part of your income
In 2011, qualified dividends will be taxed as ordinary income once again, as they were before 2003, rather than at long-term capital gains rates, which are typically lower. The higher your tax bracket in 2011 and the greater the proportion of your income that’s derived from dividends, the more significant the impact of that change.
Also, you may need to review not only your holdings but where you hold them. The way dividends are taxed can affect what type of account might be most suitable for dividend-paying stocks. When qualifying dividends were first taxed at the capital gains rate, many investors made sure their dividend-payers were in a taxable account to benefit from the lower rate. If you were one of those investors, it may make sense to review that strategy to determine if you would now benefit from holding dividend-paying stocks in your taxsheltered account instead. Of course, you’d also need to take into account any transaction costs from selling stocks in a taxable account and buying them in a tax-sheltered vehicle, since you’re normally not allowed to transfer existing holdings into an IRA or 401(k).
You hold taxable bonds
Taxable bonds typically pay higher interest rates than municipal bonds. However, if you’re in a relatively high tax bracket or expect to be in one in the future, munis can actually offer a better return because of their tax advantage, and may be worth a second look for two reasons. In addition to the new tax brackets for 2011, tax-free income from municipal bonds could become even more valuable in 2013. That’s when the unearned income of people making $200,000 a year ($250,000 for couples filing a joint return) is scheduled to be subject to a 3.8% Medicare contribution tax. Munis have traditionally been attractive to investors in a high tax bracket; they could become even more so in years to come.
Don’t forget the usual suspects
In addition to staying on top of the tax issues that complicate this year’s investment planning efforts, there are some tasks that are useful every year. A portfolio review can tell you whether it’s time to adjust your holdings to maintain an appropriate asset allocation. If you’re contemplating a sale, you’ll still need to consider how long you’ve owned the security; assets held a year or less generate short-term capital gains and are taxed as ordinary income.
If you’re selling an investment but intend to repurchase it later, be careful not to buy within 30 days before or after a sale of the same security. Doing so would constitute a violation of the “wash sale” rule, and the tax loss would be disallowed. Finally, if you’re considering the purchase of a mutual fund outside of a tax-advantaged account, find out when the fund will distribute dividends or capital gains, and consider postponing action until after that date to avoid owing tax on that distribution.
This material was prepared by Forefield Inc. Material is for informational purposes only and is believed to be reliable but no attestation is being made as to its accuracy or completeness. Please seek the assistance of a qualified tax advisor prior to making any tax-related decisions.
This is for informational purposes only and is not intended to provide specific advice. Please talk to your financial advisor prior to investing and a tax advisor prior to executing any tax strategy.