You Can't Avoid Death, but Taxes...

10/09/2012 10:45 am EST

Focus: TAXES

Nick Lanyi

Editor, High-Yield International

There's plenty of talk this election about what is going to happen to tax policy, especially for investors. Here's a short rundown of some of investors' biggest concerns and suggestions for alleviating them, from Nick Lanyi of Personal Finance.

Unless a gridlocked Congress acts soon, the George W. Bush-era tax cuts are scheduled to expire January 1, 2013. If President Obama is reelected, the top income rate could rise from 35% to 39.6%.

If Republican nominee Mitt Romney is elected, he’s expected to push for tax reform that eliminates tax-lowering deductions, such as those for mortgage interest and charitable contributions, thereby pushing more income into higher brackets. Either way, we pay.

Taxes paid on dividend income and capital gains are especially vulnerable to a significant tax hike. The Bush tax cuts lowered this rate to 15% in most cases. If this provision is allowed to expire as part of a budget deal, we could see a return to the treatment of dividend payments as normal income, which would more than double these taxes for many investors. And unless Congress changes course, most capital gains will be taxed at 20% for higher-income investors.

Politics is rarely predictable. A radical portfolio overhaul based on what might happen to tax rates would be imprudent. But it’s best to be prepared. To limit exposure to higher taxes next year, consider shifting some assets to these tax-advantaged investments:

Retirement Accounts
Tax-deferred 401(k)s, Individual Retirement Accounts (IRAs), and other retirement accounts will be all the more valuable if the tax rate on dividends rises from 15% to 39.6%.

Consider holding a greater percentage of high-dividend stocks in retirement accounts. If you’re currently in a high tax bracket but anticipate being in a lower one when you make redemptions from a retirement account, the same applies to capital-appreciation investments.

Municipal Bonds
Outside of retirement accounts, the classic tax-reduction method for income investors is to shift assets into municipal bonds and muni-bond funds, income from which is exempt from federal income tax. While sweeping tax reform could end the tax-free status for municipal bonds, the disruption this would cause to states’ ability to finance their budgets makes such a move unlikely.

Vanguard Intermediate-Term Tax-Exempt (VWITX) has low expenses and a sterling track record. Northern Intermediate Tax-Exempt (NOITX) is another solid choice with a slightly higher yield.

To avoid state taxes in addition to federal, consider state-specific muni-bond funds that focus on your home state’s bonds: Fidelity, Vanguard, and T. Rowe Price each offer several such funds.

Master Limited Partnerships (MLPs)
A portion of an MLP’s distribution is considered a return of capital, and consequently remains tax-deferred until you sell. It’s then treated as a capital gain.

Even if tax rates rise on ordinary dividends, such MLPs as Income Portfolio holding Spectra Energy Partners (SEP) are likely to retain their tax advantages, making them particularly valuable for investors in high tax brackets.

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