Commentary 1/25/2013

The recently enacted American Relief Tax Act (“ATRA”) made the Bush tax cuts permanent for most Americans. However, it changed the landscape for those in the highest tax brackets. See our commentary on January 21 for our summary of the ATRA provisions.

So what are investors to do differently, if anything? Certainly for those in the highest income tax bracket, interest taxed at more than 44% (39.6% + 3.8% + phase-outs) is not an attractive option. Long-term capital gains and dividends retain their advantage over taxable interest even though the tax rate climbs to more than 24% (23.8% + phase-outs) for those in the highest tax brackets. Tax-exempt bonds are particularly attractive because tax-exempt interest is excluded from “investment income” subject to the 3.8% Medicare surtax.

Tax-deferral perhaps becomes more effective under the new rules. Low-turnover index funds, installment sales, real estate and pensions defer taxable income or shelter cash distributions. It is noteworthy that distributions from IRAs and pensions are not considered investment income. It may therefore make sense to consider funding a non-deductible IRA in addition to maximizing pension and IRA deferrals.

Those in lower tax brackets might consider conversions of pensions and IRAs to Roth IRAs. Doing a series of conversions over several years in order to stay in the lower tax brackets may make sense. Tax-free compounding, lower taxable income long term, and no required minimum distributions at age 70 make this strategy worth evaluating for some. ATRA includes a new provision allowing conversion of a 401(k) to a Roth 401(k) for anyone. There is no longer a requirement that you change jobs, retire or reach age 59 ½.

Life insurance with its tax-deferred cash growth and tax-exempt payout at death will certainly get a lot of play. It is critical to evaluate carefully the costs and projections of any life insurance proposal. Any investment in an insurance contract is paid out as ordinary income, even if one invests in stocks, and even annuity payouts are considered investment income under ATRA.

The effect of the phase-out of itemized deductions on charitable donations may be more significant in states without income taxes like Florida, New Hampshire and Texas. Most states have income taxes, and often, in these states, the most significant itemized deductions are taxes. In states without income taxes, charitable donations may be the biggest deduction, so individuals there may get less tax benefit for donations. One can get the full benefit of charitable giving by transferring property to a charitable lead trust which has no limit on the charitable deduction. This involves careful planning, but for some it may be very worthwhile.

We add a final note about charitable donations. There has been some commentary about the effect of ATRA’s phase-out of itemized deductions on charitable giving. One should note that a similar phase-out provision with much lower thresholds was in effect from 1991 until 2006 with no significant effect on charitable giving. In 2005, that lower threshold, indexed for inflation, was $145,950. The deductions phase-out was actually phased-out between 2006 and 2009.