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Hasty Decisions May Cost More Than Higher Taxes

Matthias Tunger | Digital Vision | Getty Images

With all the ominous talk of tax increases and a "fiscal cliff" if President Obama and Congressional leaders can't agree on a plan to avert automatic tax increases on Dec. 31, some investors may be tempted to act soon to take advantage of the current tax rates.

But financial advisers say that in their rush to doing something this year, investors may end up with regrets.

"Any time you make a decision purely for tax reasons, it has a way of coming back and biting you," said Mag Black-Scott, chief executive of Beverly Hills Wealth Management. "Could you be at a 43 percent tax on dividends instead of 15 percent? The straight answer is yes, of course you could. But what if that doesn't happen? What if they increase just slightly?"

Various proposals are on the table, but the taxes the wealthy say they worry most about are an increase in the capital gains rate to 20 percent from 15 percent, which would affect investments like stocks and second homes; an increase in the 15 percent tax on dividends; and a limitation on deductions, which would effectively increase the tax bill. For the truly wealthy, there is also the question of what will happen to estate and gift taxes.

In addition, the health care law sets a 3.8 percent Medicare tax on investment income for individuals with more than $200,000 in annual income (and couples with more than $250,000).

Taking taxes on capital gains as an example, Ms. Black-Scott, who started her career at Morgan Stanley in the late 1970s, said people needed to remember that the rates were 28 percent when Ronald Reagan was president. "If they go from 15 to 20 percent, is it really that bad?" She asked. "You need to say, 'Do I like the stock?' If you do, why would you get rid of it?"

Here is a look at some of the top areas where short-term decisions based solely on taxes could end up hindering long-term investment goals.

APPRECIATED STOCK Many people have large holdings in a single stock, often the result of working for a company for many years. And the stock may have appreciated significantly over that time. But if they are selling now solely for tax reasons, advisers say they shouldn't. The stock may continue to do well and more than compensate for increased capital gains.

But there is an upside to an increase in the capital gains rate: wealthier clients may finally be pushed to diversify their holdings. "If you have 75 percent of your wealth in one stock, then it's a really appropriate time to think about this," said Timothy R. Lee, managing director of Monument Wealth Management. If the increased tax rate "is a motivating factor for some people, O.K. Letting go of that control and the pride that goes with it is a really difficult decision."

Selling stock now may also make sense when it is in the form of stock options set to expire early next year. "Do you want to take the risk the price will drop in January?" Asked Melissa Labant, director of the tax team at the American Institute of Certified Public Accountants. "What if we have a fiscal cliff or a change in the markets? If you're comfortable, do it now."

Some investors may also fear that higher taxes will drive all stocks down. Patrick S. Boyle, investment strategist at Bessemer Trust, said there was no historical link between tax increases and stock market performance.

In the most recent three tax increases, he says, "the market has actually gone up in the six months before and after." He added: "It's not that tax rates aren't important. They are. It's just that there are so many other things going on that are more important than tax policy."

MUNICIPAL BONDS Bonds sold to finance state and local government projects are tax-free now and will be tax-free next year. That is no reason to load up on them.

Tax-free municipal bonds have always been attractive to people in higher-income tax brackets. Now, advisers fear that individuals just above the $200,000 threshold, people who say they do not feel wealthy but will probably be paying higher taxes on their income and investments, will try to offset that increase by moving more of their investments into municipal bonds.

Beth Gamel, a certified public accountant and executive vice president at Pillar Financial Advisers, imagined a case where people in higher tax brackets, thinking they were acting rationally, sold stocks this year to take advantage of the lower capital gains rates and then, to avoid higher taxes next year, put all or some of that money into municipal bonds. Maybe they outsmart the tax man, but they do so at risk to their retirement.

"It will be very difficult for them to reach their long-term goals," she said, "because the yield on muni bonds is lower than stocks over time."

Or as Will Braman, chief investment officer of Ballentine Partners, said of this trade-off: "It's not about minimizing the taxes but maximizing the after-tax returns."

He suggested that people use their deductions to reduce what is owed from taxable securities.

REAL ESTATE Advisers also say they are concerned that people will consider selling their home for fear that the appreciation on it will be more heavily taxed next year. Ms. Labant said that most home sales were never taxed because the first $500,000 of appreciation was exempt for a couple (or $250,000 for a single person). Even if you are subject to capital gains tax, it is only on the amount above the exemption level.

"Don't run out and sell your home," she said, "because you may have received bad advice."

Andrew Ahrens, president of Ahrens Investment Partners in Louisiana, said he had clients worried about the taxes on investment properties. He said he became more concerned when he heard that a group of them had been given the suggestion of setting up shell companies to buy their real estate now and sell it back to them in 30 days. The purpose was to allow the owners to pay a lower tax on the appreciation and then set a higher purchase price for future tax bills.

"I talked to some of my clients, and they had substantial gains in their real estate portfolios," he said. "I asked them if they could replace it with something better. Also, when you put that money back into real estate, that gain is lighter because you've paid taxes on it and a commission to the realtor."

INSURANCE TRICKS Annuities are another area where people might rush in to avoid taxes. As with any insurance product, annuities get preferential tax treatment. They also offer a guaranteed stream of income.

But they're also very complicated products and carry all sorts of fees, like management fees and penalties for withdrawing your money early.

"I'm concerned that aggressive insurance people are going to see this as a time to sell annuities," Ms. Gamel said. "Annuities are among the most complex investment products there are. If we only have between now and Dec. 31, we don't have enough time to assess them."

SIMPLER SOLUTIONS The prevailing advice is to wait and see. Mr. Ahrens took this a step further. He said he was telling clients that whatever happened next year could be reversed in two years with the next Congress, or in four with the next president.

But if that's too long to wait, investors have an easier option. They can move assets that are likely to be taxed at a higher rate — like taxable bonds and dividend-paying stocks — into retirement accounts and defer the tax, and put assets they don't plan to sell into taxable accounts.

Above all, a healthy dose of restraint could prevent a lot of regret. "Make sure what you're contemplating makes sense," Ms. Black-Scott said. "If you have one particular point of view and your advisers suggest another, give yourself 24 hours to think about it."