By Michael Ashley Schulman, CFA

Note: This paper was first published in U.C. Irvine’s, The Paul Merage School of Business, Center for Investment and Wealth Management, Wealth Management Frontier investment journal, October 2012 http://merage.uci.edu/journal/ciwm/october-2012/2013-tax-policies.html

 

Summary:

New federal tax policies increase the incentive for tax-exempt return. This improves the appeal of tax-exempt municipal bonds, Master Limited Partnerships (MLPs), and growth oriented investments versus investments, like corporate bonds, with immediately taxable income. Nonetheless, several factors must be weighed before making a portfolio change. This paper includes tables that managers and investors can use to determine after-tax income differences on bond investment income.

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Effectively constructing investment portfolios with tax policy in mind is customarily important.  Over the last hundred years, the top rate of U.S. income taxes has roller-coastered between 7% and 94%, the top rate of U.S. capital gains, between 12.5% and 39.9%, and the threshold for top tier taxable income has varied between $75,050 and $2 million. (Citizens for Tax Justice)

 

Come January 2013, unless American tax policy is altered, several new U.S. federal government tax policies will come in force to again change these levels, notably:

  1. Higher income taxes
  2. A wider AMT tax
  3. Higher capital gains tax

Investors, accountants and portfolio managers should be aware of the changes and coordinate investment reviews and possible portfolio alterations.

 

Some immediate tax consequences, effective January 1, 2013 are:

  • An additional 0.9% tax on earned wages in excess of $200,000 for a single individual and $250,000 for a jointly filing married couple
  • An additional 3.8% Medicare tax on unearned income, specifically the lesser of net investment income or the amount by which adjusted gross income exceeds $200,000 for a single individual, $250,000 for a jointly filing married couple, and $125,000 for a separately filing married person.
  • A possible top rate on capital gains of 25% for joint filer (Citizens for Tax Justice) (Kent)

As a result, the top tax rate on income, earned and unearned, will be 44.6% (Guerriero). In addition, the large estate tax exemption, presently $5.12 million per spouse gets significantly reduced at year end, thus wealthy families will probably want to take advantage of this gifting exemption if they haven’t already. (Campione)

 

Many of the usual tax reducing investment instruments still have appeal

  • Tax-exempt municipal bonds, where the income is free of federal taxes and may be free of state taxes
  • Master Limited Partnerships (MLPs), where dividend payments largely represent a return of capital rather than income
  • Growth oriented investments that distribute little to no income and get taxed at a lower capital gains rate

However, even these instruments have been challenged recently

  • Tax-exempt munis – Congress and the administration have discussed capping or ending the tax-exemption for municipal bonds, especially based on the success that taxable bonds enjoyed under the Build America Bond (BAB) program. (Ackerman) (Schroeder) (Gleckman)
  • MLPs – Each of the last two years have seen proposals to tax pass-through entities including MLPs so there could be some headline risk.[1]
  • Growth oriented investments – As noted above, growth will face a higher capital gains tax in 2013.

Thus, any focus on these or other investments may have to be altered down the line to fit new circumstances. This desired flexibility can create an extra hurdle for investing in alternative investments with multi-year lockups that focus on these areas.

 

The Alternative Minimum Tax (AMT) patch expired at the end of 2011. It needs to be retroactively fixed before the end of 2012, or the numbers of people hit with AMT taxes will jump from approximately 4 million to 30 million. (Good Morning America) (Pianin) Without the patch, AMT payments are owed by April 2013 and would reduce U.S. GDP by about 2%. Unless Congress fixes this during the lame duck session, November 7 to December 31, 2012, Advisors may want to shed exposure to AMT municipal bonds from the portfolios of clients that would be affected.

The new higher income tax rates increase the incentive to avoid or reduce taxable income. None-the-less, tax consequences are just one of many factors[2] relevant to creating a prudent investment portfolio. The examples below roughly compare income from a portfolio of taxable corporate bonds versus income from a portfolio of tax-exempt municipal bonds. The table templates are interactive so that one can change dollar or percentage values and the results will flow through the rest of the table. Since the 2008 financial crisis, tax-exempt municipal bonds (which traditionally traded at lower yields than Treasury bonds) commonly trade at yields higher than Treasury bonds. Therefore, although tax-exempt municipal bonds professionally trade off of the Municipal Market Data (MMD) curve, for simplicity and for comparative purposes, the tables below scale them as a spread above Treasury bonds, similar to how corporate bonds trade.[3]

To focus this analysis of the new tax regime on high net worth (HNW) individuals, the table assumes that an individual or married couple already has income that pushes them into the top tax tier. The calculations examine the marginal income tax difference on a $10 million portfolio. Although changing the Treasury yield and Spread in the table will alter the dollar amounts earned, the percentage change in income lost to the new taxes or saved by investing in municipals remains constant. For example, a corporate bond portfolio will retain 14.77% less after-tax income in 2013 than in 2012, whereas a municipal bond portfolio will enjoy 17.33% more after-tax income in 2013 versus a corporate portfolio than in 2012 (Table 1). Thus the tax advantage of holding municipals is significantly greater.

 

Table 1. This table examines U.S. federal after-tax income differences on bond investment income for those where income exceeds $200,000 for a single individual, $250,000 for a jointly filing married couple, and $125,000 for a separately filing married person.

Table 1. This table examines U.S. federal after-tax income differences on bond investment income for those where income exceeds $200,000 for a single individual, $250,000 for a jointly filing married couple, and $125,000 for a separately filing married person.

Note: Yellow cells are interactive input cells; the user can change the dollar or percentage value and the results will flow through the rest of the table

 

The 14.77% reduction in after-tax income for a corporate bond portfolio and the 17.33% greater after-tax income enjoyed by a municipal bond portfolio hold true even if Treasury yields and bond Spreads change (Table 2).

 

Table 2. This table is similar to Table 1, but the Treasury yields and bond Spreads have been changed to show that even though the after-tax dollar amounts change, the percentage effects on after-tax income are static.

Table 2. This table is similar to Table 1, but the Treasury yields and bond Spreads have been changed to show that even though the after-tax dollar amounts change, the percentage effects on after-tax income are static.

Note: Yellow cells are interactive input cells; the user can change the dollar or percentage value and the results will flow through the rest of the table

 

Thus, a corporate bond portfolio for a HNW investor will generate nearly 15% less income with the new Federal tax rate.   In addition, a municipal bond portfolio will retain about 17.3% more after-tax income in 2013 than in 2012 when compared to a corporate bond portfolio. The after-tax income differences however are even larger when state taxes are factored in; the higher the state income tax rate, the wider the advantage seen with a municipal portfolio. A 9% state income tax rate on top of the new federal tax rate, means a 17.14% reduction in after-tax income (Table 3) for a corporate bond portfolio in 2013 and a 20.69% greater after-tax income enjoyed by a municipal bond portfolio relative to a corporate bond portfolio.

 

Table 3. This table examines U.S. federal and state after-tax income differences on bond investment income for those where income exceeds $200,000 for a single individual, $250,000 for a jointly filing married couple, and $125,000 for a separately filing married person.

Table 3. This table examines U.S. federal and state after-tax income differences on bond investment income for those where income exceeds $200,000 for a single individual, $250,000 for a jointly filing married couple, and $125,000 for a separately filing married person.

Note: Yellow cells are interactive input cells; the user can change the dollar or percentage value and the results will flow through the rest of the table

 

Investors and financial planners may consider selling assets with sizeable capital gains by December 31, 2012 in order to take advantage of the current lower capital gains tax rate[4]. For example, if a HNW couple sold equities with a $1 million long-term capital gain in 2012, they would incur a 15% federal tax which would equal $150,000, leaving them with after-tax gains of $850,000. However, if they sold their equities at the same levels in 2013, they might incur a $250,000 tax, leaving them with an after-tax gain of $750,000. For the couple to realize the same after-tax gain of $850,000 in 2013, a $2 million portfolio with a $1 million cost basis would have to increase approximately 6.67% in value. Therefore, one should weigh desire to sell versus investment growth expectations.

 

In summary, the new federal tax policies increase the incentive for tax-exempt income in 2013, decrease the incentive for many individuals to hold exposure to AMT municipal bonds in case the AMT patch is not fixed, and increase the incentive to sell assets and take capital gains by December 31, 2012. However, if Congress extends the current lower tax rates or otherwise changes tax policy, many portfolio adjustments may be for naught. Thus, investors are advised to weigh transaction costs, the likelihood of different tax rates being implemented, as well as the likelihood that other investors may start selling assets before year end and drive down prices. Additionally, other risk and desirability factors that contribute meaningfully to an efficient investment strategy should not be ignored.

[1] The MLP sector will probably not lose its pass-through status for federal incomes taxes based on how little support previous proposals received as well as that the nation’s largest law firms and lobbyist firms are also treated as pass-through entities, so in essence, the MLPs have the largest and strongest lobbying base on their side.

[2] Risk factors include but are not limited to: diversification, expectations, needs, risk tolerances, time horizon, and volatility.

[3] In these examples, the spread would simply be the yield from a portfolio of corporate or municipal bonds respectively, minus the stated U.S. Treasury yield. The 10-year U.S. Treasury yield is used in the examples, but a different Treasury benchmark could be substituted. If a municipal bond portfolio yields less than treasuries, a negative spread can be entered in the [Municipal Bond Portfolio, Spread] cell.

[4] The calculations for collectibles, such as art, coins, and stamps, are different; they have a maximum capital gains rate of 28% in 2012.

[Disclaimer: The information in this page is not directed to any person in any jurisdiction where (by reason of that person’s nationality, residence or otherwise) the publication or availability of the information is prohibited. Persons in respect of whom such prohibitions apply must not access this page. This is meant to be a discussion piece and should not be treated as advice, an authoritative tax guide, nor as an investment guide. Any references to tax treatments depend on the circumstances of the individual client and may be subject to change. Information provided on and available from this page does not constitute any investment recommendation. In preparing the information, we have not taken into account your objectives, financial situation or needs. Information contained herein is subject to change. All example returns, yields, and spreads are fictional and used for illustrative purposes only. Please check all information with a tax or investment specialist.]

Bibliography

n.d. Citizens for Tax Justice. <http://www.ctj.org/pdf/regcg.pdf>.

Ackerman, Andrew. “Muni-Tax Exemption on Chopping Block.” 7 April 2011. The Wall Street Journal. <http://online.wsj.com/article/SB10001424052748703712504576245530846865392.html>.

Campione, Matthew. “2013 Federal Estate Tax.” 29 6 2012. Forbes.com. <http://www.forbes.com/sites/matthewcampione/2012/06/29/2013-federal-estate-tax-the-99-verses-the-01/>.

Gleckman, Howard. “Should Congress Curb Tax-Exempt Municipal Bonds?” 28 8 2012. Tax Policy Center. <http://taxvox.taxpolicycenter.org/2012/08/28/should-congress-curb-tax-exempt-municipal-bonds/>.

Good Morning America. “Always More Taxes: Dreaded AMT Returns.” 9 2 2012. ABC News. <http://abcnews.go.com/Business/taxes-dreaded-amt-returns/story?id=15539522>.

Guerriero, Elizabeth, J.D., University of Louisiana Monroe and Parker, Michael, D.B.A., University of Louisiana Monroe. “THE CHANGING INVESTMENT TAX ENVIRONMENT: A FINANCIAL PLANNING GUIDE.” Journal of Interdisciplinary Business Studies (2012): 4.

Kent, Bernie. “Why You Need To Do Your Yearend Capital Gains Tax Planning Now.” 6 3 2012. Forbes.com. <http://www.forbes.com/sites/berniekent/2012/03/06/urgent-why-you-need-to-do-your-yearend-capital-gains-tax-planning-now/>.

Pianin, Eric. “The ‘Fiscal Cliff’ Looms Over Taxes and Spending.” 14 5 2012. The Fiscal Times. <http://www.thefiscaltimes.com/Articles/2012/05/14/The-Fiscal-Cliff-Looms-over-Taxes-and-Spending.aspx>.

Schroeder, Peter. “Wyden-Gregg Bill Would End Tax-Exempts .” 23 2 2012. Bond Buyer. http://www.bondbuyer.com/issues/119_285/senate_bill_end_tax_exempt-1008695-1.html