Morningstar Advisor - Fall 2008 - (Page 38)

Spotlight Taxing Changes Unless Congress acts, the Bush tax cuts will expire after 2010, automatically raising taxes back to rates effective under previous law. Congress is considering raising other taxes. Here’s the lineup of what Congress is considering: Capital Gains Raise the current 15% rate to 20%-25% before 2010. Treat gains as ordinary income after 2010. Qualified Dividends Tax at ordinary income-tax rates. Marginal Rates Restore tax rates at 39.6% for the highest taxpayers, up from current 35%. Social Security Wages Boost payroll taxes 2% to 4% for employees earning more than $200,000 (married couples, $250,000). Also being discussed is raising the ceiling on wages subject to taxation (currently $102,000 and indexed upward each year for wage growth.) Alternative Minimum Tax No movement. The tax isn’t indexed for inflation, capturing some 33.4 million taxpayers by 2010, up from 4 million in 2006. Congress has enacted patches instead of reforms, but the AMT’s impact is quickly growing. Corporate Taxes Close oil and gas loopholes, eliminate deductibility of CEO pay, raise corporate tax rates, limit multinational tax deductions, tax carried interest as ordinary income. Windfall Profits Tax Levy a special 25% tax on “unreasonable profits” generated by major U.S. oil companies. Source: The Tax Policy Center are telling clients to be prepared for the downside of higher rates—lower yields on their investments.” Higher tax rates, of course, increases the attractiveness of tax-shielded accounts and tax-free municipal bonds. A recent report issued by Merrill Lynch & Co. said that the soaring deficit and tax hikes necessary to combat it will make tax-free bonds much more attractive to investors. Morningstar analysts have been pounding the table for municipal bonds for nearly a year, saying that the mortgage mess has caused investors to punish munis too hard. (See “With Munis Feeling the Pain, Some Opportunities Arise” in the Summer 2008 issue of the magazine.) “Many muni bonds yield more than Treasuries,” says Russel Kinnel, Morningstar’s director of fund research. “The situation becomes all the more remarkable when you factor in taxes.” AMT: Revenue’s Secret Weapon trillion, says Michael Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md. “Congress fought about it for all of 2007 and they came to no resolution,” Kitces says. “The costs of repealing it are just far too astronomical.” Tax increases remain unpopular with voters, Kitces says. Congress, he says, is more likely to close perceived tax loopholes, enforce compliance, patch the AMT, and run higher deficits until the situation becomes untenable—forcing changes. Another taxing subject: What is going to happen to the estate tax? The exemption is currently set at $2 million with a 45% tax above that figure. The tax threshold is set to rise to $3.5 million in 2009. The tax would be repealed in 2010 and then revert to a $1 million exemption in 2011. Taxpayers would pay a maximum of 55% of anything above that amount. Before the estate-tax repeal goes into effect in 2010, Congress will reach some sort of compromise on the size of the state, a figure that Gail Fialkow, advisor with Pegasus Financial Group in Chantilly, Va., expects will be in the $2 million to $4 million range. In the meantime, estate planning will remain a moving target. “Who knows what Congress is smoking when they enact some of this stuff,” Fialkow says. Expect a Boom in Roth Conversations Social Security payroll taxes are another big worry on advisors’ minds. Pressure is mounting in Congress to increase the tax that each wage earner pays to help plug a growing hole in Social Security. One scenario would be to raise the eligibility age for Social Security and Medicare by at least five years. Both proposals could influence future retirement planning. Many advisors are also telling their clients not to expect a wholesale repeal of what has become the most despised of all taxes—the dreaded Alternative Minimum Tax. The tax, created in 1969, was adopted to prevent the rich from using loopholes to avoid paying taxes. Over the years, wage inflation has pushed more individuals into the Alternative Minimum Tax system. Lawmakers have enacted a series of patches, including one in the recent $700 billion bailout package, to keep the number of taxpayers from soaring. But the effort has been largely unsuccessful at solving the problem. So much tax is now being collected in AMT taxes that Congress is having second thoughts about repealing the tax. The cost of repealing is $1.5 The threat of higher rates is already modifying investor behavior. Planners are telling clients holding tax-deferred IRAs to convert them to Roth IRAs at today’s low tax rates. If a taxpayer is under age 59.5, the tax must be paid out of cash (not the IRA) or the taxpayer will suffer at 10% penalty. “It just comes down to whether you can afford the taxes. Tax rates are not going down,” says Fialkow. Under current tax law, taxpayers with adjusted gross income of less than $100,000 can convert a tax-deferred IRA and pay federal taxes at Holland is advising clients considering selling their businesses that they should do it this year or next. “It would be nice if the tax and capital gains rates only went up to 20%,” says Holland, noting that is probably wishful thinking. “We 38 Morningstar Advisor Fall 2008

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Morningstar Advisor - Fall 2008 Contents New on MorningstarAdvisor.com Letter from the Editor Contributors Inbox Are You Preparing for Higher Taxes? State of Financials Oracles of Alabama Investment Briefs Managers’ Investment Secrets Revealed Conformity Becomes a Growing Concern at American Gimme Shelter Location, Location, Location Rooted in Buffett, Going for Growth Keeping Little Company Away from the Numbers Consumer Confidence What about Natural Gas? TIPS to Beat Back Inflation Investing in Hidden Assets Funds That Have an Edge Come Tax Time Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar One for You, 19 for Me

Morningstar Advisor - Fall 2008

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