CPA Conference Tax Ideas: What are the Investment Implications?

The CPA profession held their annual financial planning conference in Las Vegas which I attended virtually. The main theme is that the new tax laws that started in 2013 have significant impact on affluent investors which will require more sophisticated planning. Further, the new higher tax rates may make some tax advantaged investments act as if they were a new asset class, although I would be careful not to leap to conclusions about something becoming a new asset class simply because of a new tax law.

For some investors the marginal federal tax on ordinary investment income (such as rent, interest, short term gains) if AGI is over $400,000 has jumped from 35% to 44.588% (including the Pease limitation) plus an additional 1.7% for the “PEP” limitations on personal exemptions if someone has a family of four people, which is a marginal federal tax of 46.288%. That’s a 32.2% increase in the federal marginal rate which was 35%. Add to that a California income tax of 9.3% to 13.2% (roughly 6% to 10%, net of federal refunds, after deductions and adding back AMT), for total of roughly 54.3%.

The implication of the new higher taxes is that the pain hasn’t been felt yet because investors sometimes don’t realize until they file a tax return in April that they owe extra taxes for last year’s investments. Most people making a good income are too busy to study these things, so when they are hit with a surprise tax bill (because there is no withholding on investment income) then that will affect investor behavior. Once the pain is felt then investors will search for answers and may gravitate towards a comprehensive financial planner who may in turn advocate a more risk adverse investment approach which could result in affluent sophisticated investors lightening up on their stock holdings and moving into lower risk assets. Further, investors stung by the extra taxes, may tighten their budget and buy less stock and less consumer goods, which will have bearish implications.

I would caution people that mixing tax planning with investments is not as simple as it sounds. For example a tax advantaged strategy might be to own partnership units in an oil drilling venture. However that has a higher level of risk in terms of being trapped in a closely held, illiquid investment that is difficult to sell. Further some of these may require that the investor become a partner in the business (instead of a passive stockholder) which means they take on liability should the business fail. As a rule of thumb, tax-advantaged investments such as oil drilling or real estate have lots of complications including risk of small business failure, risk of shortage of liquidity for the business, risk that the asset can’t be sold or borrowed against, risk that it can’t be held in a retirement account, etc.

Another anomaly about tax-aware investing is that is an investor may park bonds in an IRA, which is a good idea, then when stocks crash and it becomes time to buy stocks then the investor would have to sell the bonds and buy stocks inside the IRA. Then when the market recovers the future capital gain is trapped in the IRA and when the funds are withdrawn its tax status is ordinary income instead of a capital gain.

To do tax-aware investment planning an investor would need to examine his lifetime projected spending and earning and then whenever temporarily unemployed and in a low tax bracket he would need to do Roth IRA conversions so as to smooth over his lifetime average tax bracket. A more sophisticated plan would be to forecast how much cash an investor can get from his retirement accounts and pensions and compare that to his needs and then if possible seek to never sell appreciated assets in taxable accounts. This is because when someone dies the tax basis is stepped up thus making assets free of income tax on the gain if the asset was in a taxable account. A carefully done financial plan could be a key to creating an optimal outcome. Of course investments are subject to risk, including risk of changes in tax laws.

Investors should seek independent financial advice about tax aware investing. There is a lot of risk that investors could hurt themselves with flaky, dangerous tax advantaged investments, so one must be very careful. I wrote an article “Tax planning for high income California residents”.

About the author

Don Martin, CFP®

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