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Investing In a Potentially Changing Tax Environment

Brief Summary of Ideas Presented:

1. Changes in the economic backdrop, such as are now possible if tax rates effecting investors are altered, do not always have the effect on investment returns that many anticipate. For example, many incorrectly expected that a "New Normal" of lower economic growth would result in lower stock and bond returns.

2. It now appears that various taxes incurred by investors are likely to rise, if not on Jan. 1, then in the not-too-distant future.

3. But rather then rise for everyone, it seems more likely that taxes will only rise, at least within the next year or two, on a tiny percentage of "affluent" investors, given the strong opposition by both political parties.

4. Since affluent investors own up to 50% of all U.S. stock and bond investments, this group's reactions could have a big effect on the markets.

5. All investors, whether affluent or not, should consider three main strategies for keeping their taxes as low as possible. They should also consider the potential opportunity to possibly profit from the likelihood that many investors affected by the tax increases will react to the changes by either selling or buying certain types of investments.

With the election over, it appears we may be about to embark on a "new era" of higher taxes. If so, the question remains will any such increases lead to changes in the way you should think of your different investments. This is the question I will attempt to tackle in this article.

Will Tax Increases Lead to Changes in the Outlook for Different Investments?

Of course, nothing can be said with certainty until Congress and President Obama agree on changes, or on what I perceive as a long shot, do not act in December and thus precipitate the "fiscal cliff" (but perhaps only temporarily). However, I believe that investors should be skeptical whenever it is proclaimed that we are entering a "new era" with broad implications for longer-term investing. Likewise, they should exercise caution, even after whatever changes are finally announced, that they themselves (or even some expert) can figure out what adjustments they might be able to make to their investments to either potentially profit from the changes or avoid potential losses. One only need to look at prior examples of this "big changes ahead, savvy investors should react" thinking to see why.

The "New Normal" Hasn't Turned Out Bad as Many Expected

Back in June 2009, investment guru Bill Gross used the phrase "New Normal" to describe the anticipated reduced global growth prospects and what he felt would be considerably lower rates of return for stock and bond investors. He argued that an investor should probably follow humorist Will Rogers who said "he wasn't as much concerned about the return on his money as the return of his money." If one had followed such an approach, as many did, and gone into the most conservative investments designed to avoid losses at all costs, the growth of their portfolio would have indeed suffered.

While Gross may have gotten his economic forecast for growth correct, his pronouncement of reduced investment returns has proven way off the mark over the last 3+ years. If we look at the return of the S&P 500 Index over the 3 years that followed, from July 1, 2009 through June 30 2012, we see that the Index returned an annualized 16.4%, way ahead of its 10 year annualized return through the latter date of only 5.3%. And what about returns on bond funds, his specific area of expertise as manager of the world's biggest bond fund, Pimco Total Return? The 3 year annualized return for all taxable bond funds for the same period, as reported in the Wall Street Journal, was 8.1% as compared to the 10 year annualized return of only 5.3%.

Near Zero Interest Rates and Quantitative Easing Did Not Lead to Excess Inflation

Drastic actions by the Fed in response to the financial crisis began in Dec. 2008, which included a zero Fed funds rate and quantitative easing (QE). This too led some to the view that big changes were afoot, this time with regard to inflation if the policies were not halted quickly. Specifically, prominent economists strongly feared a tide of unwanted inflation or even hyperinflation. In fact, several Fed Committee members themselves have long argued that position. Specifically, back in July 2009, Federal Reserve Bank of Philadelphia President Charles Plosser said in an interview: "I think we will probably have to begin raising rates sometime in the not-too-distant future [to prevent inflation]."

Another Fed participant, Dallas Fed official Richard Fisher, has also argued against the Fed's easy money policy, also going back to the same time period. Ditto for Richmond Fed President Jeffrey Lacker who said in Aug. 2009 it might be time to pull back from QE. The argument was further promoted to the public by several media-savvy individuals and economists including former Fox News commentator Glenn Beck, not to mention a few prominent politicians.

Of course, higher inflation would have meant higher interest rates, and as a result, poor returns on most types of bonds, and likely stocks as well, something many of this argument's adherents pointed out. Yet fears of inflation taking off have completely failed to materialize. As noted above, bonds have done quite well under quantitative easing, in some cases even outperforming stocks over the last year. Inflation protected bonds have done pretty well too, but not as well as various other categories of bonds, a result contrary to what would have been predicted by those who believed the inflation hawks.

These examples show, as do innumerable others, that those who fervently argue for both a likely drastic change in the economy to be followed by either favorable or unfavorable effects on certain investments, are apparently assuming what I would consider almost impossible powers in trying to predict accurately not just one nearly unpredictable happenstance, but two. Neither economics, nor certainly not investing, are the type of disciplines that have proven to be amenable each half of these kind of "new era" predictions, each half having little more than a 50/50 chance of being correct, especially a few years out. For many people including myself who have followed the accuracy of such predictions, making such projections is nearly always a dicey proposition leading to what should be a healthy skepticism for the words of such advice givers whose forecasts have previously turned out clearly wrong.

Questioning the Two Basic Assumptions

Specifically, given the above, one might reasonably question

- first, the premise that we are soon to enter a significantly changing environment for taxes at all, and

- second, the assumption that, even if we do, it will likely suggest big changes for investors who wish to maximize their returns.

Let's start with the first assumption, namely that taxes will rise significantly.

Without repeating too much of what you undoubtedly already know, on Jan. 1 federal taxes are scheduled to return to the higher rate structures that prevailed during the Clinton presidency. However, there is still time for modifications since most economists and even politicians think that, unless modified, universally higher rates will hurt the economy enough to throw us back into a new recession. So, it would appear to be highly likely that some of the expected higher taxes will be modified, postponed, or even eliminated. It is important to note that President Obama is proposing increasing taxes only for the top 2% of taxpayers. Therefore, it is extremely unlikely that such rates will wind up higher for the remaining 98%.

But (and this is a big but) data shows that these affluent individuals own over a third of all stocks, mutual funds, and ETFs, and perhaps closer to one half. Therefore, even a change in the tax environment for just the top 2% could well influence the price action in the markets that the remaining 98% of us invest in.

Here is a thought given that Jan. 1 is fast approaching. Perhaps it will be decided to phase in these higher taxes gradually, giving those investors affected more time to plan. If an increase in the capital gains rate for affluent investors is going to (or is expected to) start immediately on Jan. 1, many can be expected to rush to sell before the year's end to lock in the lower rate. This, in turn, is likely to cause a significant drop off in stocks. Such selling could draw in even non-affluent investors who fear losses on their investments. Such a precipitous drop in the stock market could further heighten the possibly of a recession or even trigger a dreaded reduction in the current subpar level of job creation. Rather, if an increase is postponed to say June 30th, whatever selling that might occur will be much more gradual, likely preventing a harsh blow to the economy.

Of course, since the U.S. runs a huge deficit, keeping tax rates from going up for 98% of taxpayers will make it even harder to make any progress in reducing it, a goal all politicians say they want. So how can the government keep most rates from going up and still reduce the deficit? Of course, we could merely chop spending, but few would be willing accept the huge cuts that would be necessary to bring spending back into balance, and to eventually pay off our back-indebtedness.

Therefore, the likely fiscal cliff solution would be that while the more obvious tax rates, as reflected in marginal income tax brackets, may not go up much if at all, the less obvious means which people use to lower their overall taxes likely will, although perhaps not on Jan. 1. The latter include the amounts individuals and businesses are allowed to deduct or exclude from their income as well as the amounts investors are required to pay when they make a gain on their investments either through a sale or from dividends spun off from stocks. These latter taxes will likely go up enough, along with government spending cuts, to gradually begin to reduce the budget deficit.

All investors, of course, will have to get used to it if capital gains and dividends revert back to pre-George W. Bush days, as worriers about the "fiscal cliff" fear. During the first Clinton administration (1992-2000), the capital gains rate was initially 28%, but then cut to 20% in 1997 as compared to the 15% rate now in effect, enacted in 2003 during the Bush years. Even more dramatic, the tax rate that most investors paid on stock on dividends during the Clinton years was no different than their overall tax bracket, maxing out at 39.6% as compared to a maximum of 15% now. But if the fiscal cliff is avoided and something like the Obama proposal to raise these investment related taxes only on the top 2% prevails, any such rise for all taxpayers may only happen, if at all, further down the road. (In my opinion, we have had it almost too good to be true with regard to these investment-related taxes for quite a long time. But since the government is currently only receiving less than 65% of all the money it is spending according to the Office of Management and Budget, the incentive for many lawmakers to change this would appear to be great.)

Thus, with regard to my first point above, unless no action at all is ultimately taken with regard to the fiscal cliff, the premise that we are going to enter a significantly changing environment for taxes does not appear to be a valid assumption. But even if the cliff did happen taking taxes back to where they were during the Clinton era, investors should consider the following fact: The Clinton era was a good one for stock investors. During his two terms, an index of stocks' total return rose a cumulative 233.6%. What this suggests is that higher marginal rates, and even much higher taxes on investment returns, did not in and of themselves lead to low stock returns.

Let's now return to my second assumption as stated above regarding changes to investor strategy. Whether sound planning or not, I expect, as noted above, many affluent investors will react almost reflexively to take gains at the prospect of higher capital gains taxes, especially if the date of the rise appears to be right around the corner. And some may reconsider the appeal of stock investments generating significant dividends (This already appears to have been somewhat the case following the election.) Note however that for such investors in tax-deferred accounts, there should really be no reason at all to react in this way since capital gains and dividends in these accounts are not taxed as such.

What to Expect in January and Beyond

Given the aversion of both Democrats and Republicans to raising the marginal tax rate on the great majority of taxpayers, what we can most likely expect, then, is that wealthy taxpayers who are investors will be the ones who will be most directly affected by the potentially changing tax environment. But, if investor taxes rise for a bigger proportion of the population, then and only then, can we consider whether the tax environment has really significantly changed.

Legendary investor Warren Buffett recently laughed off concerns that higher capital gains taxes could change how individuals invest in stocks or bonds: "Never in 60 years of managing money have I come up with an idea and had someone say 'I'd do it but the tax rates are too high'." But, obviously, capital gains are only part of the picture; stock investors may be facing significantly higher taxes on their dividends.

While Buffet's comments may ring true when considering capital gains, they may not capture how investors factor in dividends in choosing investments. If several investments have different tax consequences, it would make sense to select the ones that have the highest potential after-tax returns. Therefore, if looking at some investments with lower tax rates and otherwise equal pre-tax return potential, one would logically prefer the lower taxed ones.

Given the likelihood that capital gains and dividend taxes will rise for affluent (and perhaps for all) investors, even if not immediately on Jan. 1st but over the next year or so, even non-affluent fund investors should be prepared to consider possible short-term and long-term effects as some investors re-appraisal their portfolios. If so, one might begin planning how to come out ahead. Specifically,

-Consider switching to investments that offer tax advantages.

While investment taxes on stocks were extremely low, it made a lot of sense to buy income-producing stock funds or ETFs. This became especially true as income spun off by most bond funds dropped to previously unimaginable levels. If tax rates on stock dividends go up, this appeal becomes less. Perhaps the most tax advantaged investment left will be municipal bonds since none of their earnings are subject to federal tax, and may even be free of state taxes as well.

It would appear unlikely that muni bonds will lose some or all of their tax advantages, as has been mentioned as a possible outcome of fiscal cliff negotiations, at least in the next few years. Without the advantage offered to investors, states would have to pay borrowers at a higher rate, hurting their already stressed budgets even more. While there is always the possibility that muni bonds will lose some or all of their tax advantage, if they do survive intact we could definitely see an increased movement toward this type of fixed income investing, and in fact already have since the election. And especially since affluent investors will likely be making these moves, all investors might consider making them as well to benefit from rising asset values.

-Consider raising your allocation to stock funds/ETFs, especially those with a growth orientation.

Stock funds themselves offer tax advantages over most other (non-muni) types of bonds. Why? Because unlike bond funds whose major appeal is income, subject to tax at your top tax bracket, stock funds major appeal is the potential for capital gains when held over the long term. Even if capital gains rates return to Clinton-era levels, your gains will still be subject to lower tax rates than for ordinary income. But given that stocks with above average dividends will be less appealing now, you should probably look more than before to funds in the Growth category as opposed to those in an income-generating category.

But always remain mindful of asset category valuations. In other words, do not invest solely to try to come out ahead on taxes, especially if you can see that any particular category appears overvalued while an alternative appears undervalued.

-Pay attention to which types of accounts your investments are held in.

Say, for example, your allocation is currently 60% of your overall portfolio to stock funds/ETFs and 40% to bond funds. Assuming you have both taxable and non-taxable retirement accounts, you should continue to favor stock funds/ETFs with the most capital gain potential for your taxable accounts. This usually includes Growth funds and those managed funds which have a high turnover rate. Conversely, you should endeavor to have any stock index funds with little capital gains, and any funds that generate a lot of income, including corporate and high yield bond funds, within your retirement account. If you require immediate income from bonds or income-producing stocks, these, of course, should remain in your taxable account to maintain easy access.

If your investment portfolio is not set up this way, it is often possible to change it by making some appropriate exchanges. So, if you currently have both stock and bond funds in both your taxable and non-taxable accounts, you can exchange the bond portion of your taxable account into an appropriate stock fund. Meanwhile, within your retirement account, perform an equal-sized exchange from a highly similar stock fund to an appropriate bond fund. Suddenly, although you still have the same amount of money invested in stocks and bonds, your portfolio has become more tax-efficient. (Note: Of course, in this example, you may incur a capital gain on the sale of the bond fund.) Finally, don't forget that new Roth retirement accounts, and conversions, can save you huge amounts on taxes as compared to non-Roth accounts if you determine you can successfully go that way.

But guess what? The above 3 strategies are not really different after Jan. 1, 2013 than what tax-conscious investors should have been following before then. Therefore, my second assumption of the need for big changes for investors who wish to maximize their returns is not likely valid either. However, since the tax implications of investments are now being pushed more to the forefront of investors' consciousnesses, and since the differential tax treatments for different types of investments and accounts are becoming even more apparent than before, it will likely make even more sense than before to realize how much money can be saved over long term by following these 3 strategies.


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