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Of course, many investors didn't incorporate such prospective levies into their investment strategies and tax planning, since those taxes wouldn't take effect until January 1, 2013, and there were ample questions about whether the ACA would survive judicial review. However, once the U.S. Supreme Court upheld most of that law on June 28, the need for thoughtful tax planning before year-end took on greater urgency.
After all, long-term capital gains taxes are slated to jump from 15% to 20% in 2013, and top earners may see their taxes on ordinary dividends rise from the current 15% to 43.4% if there are no changes in the current tax law—the highest rate since the mid-1980s. (See Chart 1.)
Source: Goldman Sachs, based on Treasury Department data as of May 2012.
The 23.8% long-term capital gains tax rate includes the 3.8% surtax on net investment income for couples with a MAGI of $250,000 or $200,000 for singles.
A Muni-Splendored Thing
As presidential candidates debate the wisdom of planned tax hikes and federal tax officials scramble to codify the tax provisions of the ACA, one investment option that has drawn greater attention is to allocate more funds into tax-free municipal bonds, since interest from those bonds appears likely to remain exempt from federal taxes in most cases. [It should be noted that the income from municipal bonds may be subject to the alternative minimum tax, however.]
Of course, much could happen between now and Election Day. But suppose Congress makes no changes in the current law and the top marginal tax bracket rises from 35% to 39.6% in 2013. In that case, the taxable equivalent yield of a hypothetical municipal bond with a yield of 4.29%2 would be more than 6.98%—a rather enticing prospect in a slow-growth environment fraught with uncertainty.
For example, suppose a working couple in the top tax bracket with a large IRA and an adjusted gross income above $250,000 has $50,000 of net investment income. (See Table 1 for examples of what will and will not be considered investment income.) If that couple converted their traditional IRA to a Roth IRA this year using their investment income to cover the taxes, not only would they avoid the 3.8% investment income surtax that takes effect next January, but also they would have a retirement account potentially free of federal income taxes. This strategy may especially appeal to investors who believe taxes will go up if the federal fiscal problems become worse in the years ahead.
Source: Ed Slott's IRA Advisor, May 2010, and Smart Money, June 28, 2012.
Shift and Shout
While the specter of higher tax bills may spur chilly feelings in the summer, there are a few more options worth adding to your to-do list. First, talk to your financial advisor, accountant, and/or tax attorney. Depending on the income-generating investments in your portfolio, you may want to look at shifting income in 2012 in order to reduce net investment income and adjusted gross income in 2013 and beyond. Also consider income acceleration strategies, such as harvesting capital gains or taking retirement distributions in 2012 before the taxes on them go up.3
Last, but not least, don't forget to contribute as much as you can to a retirement plan on a pretax basis, whether it's a 401(k), a 403(b), or a 457 plan. Not only will that help lower your MAGI, but also it potentially might reduce or eliminate your exposure to the 3.8% surtax.
Risks to Consider: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. The income from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-free income. In addition, bonds may be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. No investing strategy can overcome all market volatility or guarantee future results.
Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.
A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.
Taxable equivalent yield is the pretax yield that a taxable bond needs to possess for its yield to be equal to that of a tax-free municipal bond. It does not reflect state and local income taxes or the alternative minimum tax, if any and will vary based on each investor's tax bracket.
Please note that there may be administrative fees and other costs involved in a conversion to a Roth IRA.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.