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The 1040 Blues

Paul Sullivan, The New York Times
Tuesday, 12 Feb 2013 | 12:46 PM ET

Even those who closely followed the numbing, eye-glazing and, at times, frustrating so-called fiscal cliff drama of late December — and people could be forgiven for tuning it out because it coincided with New Year's Eve — find themselves trying to figure out the best angles through the tax increases wrought by the deal. And if they are not scratching their heads now, wait until April 2014, when they could see a drastic increase in their tax bill.

Consider these two situations.

First, a person has income of $350,000, which is under the $400,000 threshold that sets off the highest marginal income tax rate and an increase in the capital gains tax to 20 percent, from 15 percent. That income is, however, sufficiently high that the Medicare surcharge of 0.9 percent on wage income and 3.8 percent on investment income has been applied. If that person sold a large amount of Apple stock, with over $1 million in capital gains, would those gains be taxed at the lower or higher capital gains rate?

In the second case, a person has an annual salary of $100,000 and sells a home that she has rented out for years. Having owned it for several decades, she has capital gains of $400,000. Would the person pay 15 percent because her wage income is under $200,000? Or would she pay various and higher rates because her total income would be $500,000, pushing it through the thresholds for the Medicare surcharge and higher capital gains rate?

Both situations came from a real estate developer in Baltimore, who asked not to be named because he "did not want to come across as gaming the U.S. Treasury." Far from gaming the system, he was asking questions many Americans should be asking now to prevent a surprise come 2014.

In the first situation, the person would qualify as rich under the new tax structure and end up paying more, as President Obama intended. But the less-well-off person in the second situation is the one who really loses, because her tax bill would have been much lower had she sold the rental property last year.

To an accountant, the questions about tax liability are straightforward, but the answers may surprise people not used to such calculations. Both cases deal with how taxes are stacked on top of one another. That hasn't changed: taxes on wage, or ordinary, income come first, with capital gains taxed on top of that. Then come the details of the new rates and the variables of individual cases.

Robert Keebler, a certified public accountant with his own firm in Green Bay, Wis., said that in the first example, the large capital gain in a stock sets off the higher tax rates. The first $50,000 in capital gains would be taxed at 18.8 percent, while all the capital gains above the $400,000 threshold for the highest capital gains rate would be taxed at 23.8 percent (both rates include the Medicare surcharge).

The second example is more complicated, he said, because the owner of the rental house would have been able to deduct improvements made to the house over the years, although the same stacking of taxes would apply. But even this hypothetical $100,000 wage earner would have to pay the Medicare surcharge over $200,000 in income — even though it was both earned income and capital gains. And everything over $400,000 is subject to the higher capital gains tax as well. She would also lose some percentage of her deductions.

Mr. Keebler cautioned people against rash reactions to such new tax realities. "You have to let common sense prevail," he said. Even with capital gains taxed at 20 percent, he said, "you still get to keep 80 percent of the value. You may want to hedge things, but you don't want to put off selling things because of taxes."

But answers like this, while logical to an accountant, might not dissuade worried investors from choices that could sidetrack their long-term investment goals. Some investments driven by tax avoidance that have drawn attention since the year-end fiscal deal could cost people taxes in other ways, while some work for people at certain ages but not at others. Some that promise tax savings could deliver them at the cost of a total loss of that investment.

Higher tax rates are "going to make people do things that are economically not sound, and they may not even work," said J. Leigh Griffith, a partner at Waller, a national law firm based in Nashville. "Whether this is enough to push people into aggressively looking for shelter-type things, they'll certainly have a lot of promoters pushing them."

Here are four questions investors should ask themselves before making an investment aimed at avoiding the new taxes.

IS IT SOUND?

There is an adage about taxes and investments that accountants and advisers like to roll out: don't let the tax tail wag the investment dog. As with any cliche, there is some truth to it.

Vehicles that exist solely to shelter taxes could present problems. Mr. Griffith said the last great period of tax avoidance was the years leading to the 1986 tax reform. He recalled people investing in cattle-feed operations to get a one-year deferral on taxes. Most of the people he knew who did this lost some or all of their money.

"You provided low-cost funding for the cattle owners," he said. "Typically these were poorly run operations, and they lost money."

While it is too early to tell if there will be a rush to create similar shelters today, Mr. Griffith said he asked his clients to be sure an investment was economically viable before they made it. He is worried that green energy credits might induce people to invest in businesses that could not survive without the subsidies. He singled out credits for the development of algae as a biofuel.

"I know fossil fuels aren't popular, but is algae really a viable long-term addition to domestic energy?" he asked. "When we have people doing things primarily for tax, they generally don't work out well. What happens when that credit runs out?"

Real estate is another area where people could do something to save taxes that hurts them in the long run. Under Section 1031 of the Internal Revenue Code, revenue-producing properties, like apartment buildings, can be exchanged so no gains or losses are registered for tax purposes. This is how many real estate empires have been built, with the gains untouched until the owner dies and his heirs inherit the properties at their current value.

But the tax savings are not always worth it. "People had done well and they would exchange that property for one that wasn't as good," said Robert Stammers, director of investor education for the CFA Institute. "In order to save a little on taxes, they lost their shirt on the new property."

He said a core issue with this and other tax-driven shelters was people over-allocating to certain risks because of a focus on tax.

DO YOU UNDERSTAND IT?

While it may seem obvious that people should understand where they are putting their money before they do it, that is not always the case.

In the boom years, hedge funds were all the rage. Their returns were so high — 15, 20 or 30 percent year after year — that it was easy to overlook their high fees, lack of liquidity and opaque manner of investing. Many funds have since fallen to earth — or their investing practices have been called into question — yet they continue to charge a typical management fee of 2 percent of the assets and 20 percent of the profit. And there is no guarantee people will be able to take their money out when they want it.

For Shawn Rubin, managing director at Morgan Stanley Wealth Management in New York, the issue is more granular: what are the after-tax returns, and are they worth the amount of risk that is involved?

Mr. Rubin said many investors did not understand just how low the after-tax return could be on hedge funds.

He ran through a series of calculations that took into account how the returns were calculated, tax rates and the reduction of personal deductions for people earning more than $250,000 a year (or $300,000 for a married couple). He envisioned a situation where a return of 8.75 percent from a hedge fund owned by someone in the highest tax bracket in a high-tax state like New York could be whittled away to under 1.6 percent.

"The case against hedge funds today is on the net, after-tax return," Mr. Rubin said. "The tax inefficiency, the 2 and 20 fee and the lack of liquidity make it a tough argument."

He said investors should look for at least a 10 percent pretax return on a hedge fund investment or go somewhere else.

On a more popular level, investments in life insurance and annuities can seem like good ways for money to grow tax-deferred until someone needs it. But annuities, for example, often charge high fees and restrict how long the money has to be in an account before it can be withdrawn. And it is hard to tell how much the insurance agent selling such vehicles is making from the deal — an amount that could sway how persuasive he is.

Insurance is a way to defer taxes and to pay a benefit to heirs, while annuities can certainly provide a steady stream of income in later years. But buyers of both products need to consider them like any other investment, with risks as well as benefits.

"When insurance is sold as income replacement or sold to pay estate taxes, there's a clear insurance need," said Patrick S. Boyle, investment strategist at Bessemer Trust. "When it's sold as an investment or pure tax deferral, you just really want to understand what you're getting and what it costs you. Then you need to make the decision if the tax deferral is worth it."

Above all, Mr. Boyle said, people should take the time to figure out how much that tax deferral will cost them, a calculation that may not be as easy as it seems with insurance.

Another common tool to delay taxes is to defer income into 401(k) plans and, for senior executives, into deferred compensation plans sponsored by their companies. While 401(k) plans have contribution limits and restrictions on withdrawals until age 59 1/2, they are also protected if the company goes bankrupt. Deferred compensation plans do not have the same protection, a risk that became clear when Lehman Brothers went bankrupt and executives with deferred compensation became creditors of the company.

When executives decide to defer income, they also need to make some decisions that may be hard to predict, like when and how they want the payments to come back to them.

"Given how high tax rates are, the longer you defer, the lower the present value of your taxes," Mr. Boyle said. "But if something really bad happens to the company, your deferred compensation becomes subject to creditors. You might not get it or you might get part of it."

This risk to people's financial health can be compounded if they also hold a lot of company stock. And unlike 401(k) plans, deferred income offers limited ways to withdraw money before the date you set, said Paul Lee, a national managing director at Bernstein Global Wealth Management.

"You have to make sure this is money you want and need in retirement," Mr. Lee said.

IS IT RIGHT FOR YOUR AGE?

Two investment options attracting a lot of attention for how they are taxed are master limited partnerships and municipal bonds. They receive favorable tax treatment, but how favorable depends on more than the rate.

Master limited partnerships, which are usually set up to transport energy, are structured so the dividend is only partly taxed. This happens because the dividends contain what is called a return of the principal, and it lowers the immediate tax bill.

Joanne E. Johnson, managing director and senior wealth adviser at J. P. Morgan Private Bank, said this was a great investment for couples in their 70s who want to maximize the yield on investments in a tax-efficient way.

But the reason it works for them from a tax perspective is exactly why it would not work for couples in their mid-30s with many working years, and expenses, ahead of them.

The structure of the dividend, she explained, means the part that is untaxed reduces your cost basis — essentially the price you paid for the shares. If you eventually sell the shares, the part that was untaxed when you were receiving dividends will be taxed as ordinary income. If you hold the shares until you die, the value of the partnerships will rise to their price on your date of death for estate tax purposes.

"If you sell when you're alive, you're going to have a huge tax problem," Ms. Johnson said. "The 35-year-olds would have to hold them for 60 years or it would have a dramatic tax impact on their portfolio."

There is not such a stark tax picture with municipal bonds. The interest on them is tax-exempt, a good thing for wealthier investors. But that does not mean people should load up on them.

The risk of municipal bonds, beyond the possibility that the deductibility of their interest may become limited, an idea floated by President Obama, is that as the economy improves, people will sell them for higher-yielding investments, reducing their value. This is where comparisons need to be made.

Ms. Johnson said the couple in their 30s might not be in the highest tax bracket and so would not need to shelter as much income. The trade-off between falling values and tax savings is not strong enough, she said.

A couple in their 50s would have to do a different calculation. They would need to weigh the after-tax return of corporate bonds versus the tax-free returns on municipal bonds. For some, she said, the after-tax return on corporate bonds may be better. For the couple in their 70s, municipal bonds serve as a good hedge against high taxes.

Both investments show that investors need to ask detailed questions about how an investment will work in their situations.

IS IT WORTH PAYING TAXES?

With all this complexity, there is an argument to be made for just paying taxes and moving on. This is rooted in another crucial component of investing: managing risk.

Consider a concentrated position in the stock of the company that employs you (and manages your deferred compensation plan). There is a point, usually around 10 percent of your net worth, when advisers tell you to reduce the holding. It is too risky, particularly when something could happen to the company that you don't expect — think WorldCom's bankruptcy.

But while most people should diversify from a wealth perspective, they might be held back by the fear of a large tax bill. If that stock has grown a lot over the years, there could be substantial capital gains. They might also think, rationally or otherwise, that the stock will keep climbing.

Stock options, which give the holder the right to buy a stock at a set price, are something people often hang on to because they are taxed at the higher rate of ordinary income, instead of capital gains, when exercised. That is fine when the stock is rising.

"If you hold on to them because you're afraid of being taxed at the high end, the stock could fall and your options could be worth zero," said Dan Eagan, head of the wealth management group at Bernstein Global Wealth Management.

This is where the best advice for tax-efficient investing may be having a specific investment plan and being vigilant about which accounts own what. Investments like hedge funds and taxable bonds could be put into tax-deferred accounts, while assets that generate lower taxes, like growth stocks, could be held in taxable brokerage accounts.

Brittney Saks, the United States leader of personal financial services at PwC in Chicago, said any single-minded focus on taxes was a bad idea.

"Do you really want taxes to be the primary driver of your investment decision?" she said. "No. You could get an answer that isn't right for you personally."

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  • A reporter and editor, Robert Frank is a leading authority on the American wealthy for CNBC.