Many advisors foresee higher personal tax rates as soon as next year, especially for their affluent clients. Even if Washington manages to enact nothing over the next 15 months, rates will automatically revert to loftier levels in 2011 after the sunset of the Economic Growth and Tax Relief Reconciliation Act of 2001.
"A lot of tax planning is trying to anticipate what future rates will be," says Mike Tedone, the chief compliance officer and director of Filomeno Wealth Management in West Hartford, Conn. Like many planners, Tedone is peppering client meetings with talk about accelerating income into 2009 and deferring deductions to later years-the opposite of traditional year-end advice.
"Rising tax rates shift normal tax planning on its head," says financial advisor William Jordan, president of the Sentinel Group in Laguna Hills, Calif. "For the last 20 years, we have been operating in a declining tax-rate environment and all of our conventional planning is based on that. Now there has been a fundamental shift."
Take Losses, Or Gains?
As an example, says Jordan, "instead of taking losses, this year we will suggest that clients realize gains, to the extent they have gains. Although we don't advise taking action based solely on tax implications, we do think rates on gains are going up." The Obama administration has proposed raising the capital gains tax from 15% to 20% for individuals in the highest two ordinary brackets. Unless new legislation arrives before the expiration of the 2001 law, 20% will be the rate for taxpayers in the top four ordinary brackets come 2011. Either way, Jordan wants to beat Washington to the punch.
"You have to compare the tax on a gain triggered now versus a potentially larger tax on a potentially larger value later," explains CPA Paul Beecy, a Boston partner at international accounting firm Grant Thornton LLP. He also generally advocates recognizing gains this year.
But with a private business, it's different, Beecy says. "Owners know their product pipeline, marketplace, clients and suppliers, so they have insight into incremental value that could be forthcoming. An analysis we did for a client found that it wouldn't take many multiples of a higher EBITDA to offset the potential increase in tax rates."
When it comes to losses, there's less agreement among practitioners about what to do. Jordan says, "If you can defer losses, that is to your advantage. They'll be worth more later" if they offset gains or ordinary income that's taxed at rates higher than today's.
However, booking losses now and carrying them to future years might accomplish the same objective. Accordingly, Coghlan Financial Group Inc. in San Diego is taking losses as usual. "The opportunity to capture tax losses won't be there forever. The odds of having capital gains and fund distributions in the future are pretty good," says the firm's senior vice president, Josh Willard.
Repositioning Portfolios
The specter of rising tax rates is also affecting how advisors redeploy proceeds after recognizing gains and losses. Higher ordinary rates may suddenly render tax-advantaged investments more attractive than fully taxable ones for some clients.
Another issue is qualified dividends, which have been taxed as long-term cap gains since 2003. "Obama has indicated he would prefer to keep it that way," says Mark Luscombe, a federal tax analyst at CCH, the business info provider in Riverwoods, Ill. That effectively means taxpayers in the top two ordinary brackets would experience the same increase on dividends as on their long-term gains. On the other hand, if no new legislation is passed, the sunset of the 2001 act will turn dividends into ordinary income. "That's actually a more drastic change," Luscombe says.