Many investors are unaware of new tax that will be levied as part of the Supreme Court’s decision to uphold President Obama’s health care reform. The investment tax, as it is being referenced, will add 3.8% to dividends, capital gains, rents, royalties, annuity income, and interest. For many investors this alone will have enormous ramifications, especially for real estate investors and those that have targeted high yield. As if yields weren’t low enough! If the Bush tax cuts are allowed to expire this could push the top tax rates on capital gains from 23.8% to 43.4% (source: WSJ B7, July 1).
Estate and Retirement Implications:
For many investors acting sooner rather than later will be critical. Maximizing tax deferred strategies will offer investors more advantages than it has historically. Making sure your trust is set up in a way that takes advantage of lower tax strategies as well as optimization of IRA’s will not only be important but critical. For small businesses taking advantage of higher contribution options such as SEP contributions or even defined benefit plans will not only be beneficial, it will be imperative.
I have always been a fan of Ed Slott, a well-known speaker on the advantages of IRA’s. He routinely says investors’ exude a ton of effort to save a few nickles on investments but completely ignore the biggest risk to their retirement nest egg. That’s right! Ed explains that Uncle Sam views your investment portfolio and your IRA as low hanging fruit to fill their coffers. Ed recommends utilizing IRA’s to their max as well as embracing Roth IRA conversions when possible. I couldn’t agree more even though I can fully empathize with the difficulty of taking a large tax bill now for a benefit down the road. I often think these types of decisions investors often put off for a time down the road but as you can see with the taxes just levied the cost of waiting will be high.
I asked Bob Sytsma, a partner at one of the largest regional accounting firms, for his opinion without any lead as to what I was writing about and this was his response:
The 3.8% tax will inspire people to minimize the effect by managing their AGI and investment income, considering tax-exempt bonds, converting IRAs to ROTH IRAs, accelerating sales of businesses to 2012, accelerating installment sales, and selling a home in 2012 if the gain exceeds their exemption ($250,000 and $500,000).”
Clearly we are on the same page!
Over the long haul, dividends have ranged from about 1/3 to half off investor returns. While our firm has always been fond of dividends, we have always considered a strategy of targeting dividends to be too risky because it overweights sectors such as financials. Now the risk reward benefits of such a strategy will be diminished further. Instead, we believe investors should invest based on other fundamental characteristics neither targeting nor avoiding. Investors often target dividends because they believe it to be lower risk. Why not target risk itself and let dividends do what they will?
Another aspect of portfolio management, as it relates to the new law, is turnover. Because the capital gains tax is also expected to increase, constructing a low turnover portfolio that you can stick with will be more important than ever.