As of this writing, Congress and the President were still wrangling over how to avoid the “fiscal cliff” that will bring dramatic tax increases and spending reductions if no action is taken. While we avoid conjecture when it comes to pending tax policy, we can offer guidance, including prudent measures investors can take now, regardless of any final legislation that might emerge.

The highest tax rate on long-term capital gains is currently scheduled to revert to 20 percent, from the current 15 percent levy, on January 1. Qualified dividend income (including dividend income generated by our high-yield Dow model) is also taxed at 15 percent presently, but is set to be taxed as ordinary income at a maximum statutory rate as high as 39.6 percent.

Health care reform adds an additional burden. In order to help finance the Affordable Health Care Act (AHCA), married taxpayers who file jointly and who report more than $250,000 in wages and self-employment ($200,000 for single taxpayers) will face an additional levy (also known as the investment income surtax or Medicare tax) of 3.8 percent. This surtax will be applied to the lower of their net investment income (interest, dividends, capital gains and other amounts) and the portion of their modified gross income (MAGI) in excess of the $250,000/$200,000 threshold. IRA distributions and Social Security income are not subject to the tax, but these flows may push reported income above the threshold, rendering at least some investment income subject to the surtax.

Despite the threat of a higher tax rate on long-term capital gains beginning next year, investors should not rush to realize gains by year-end. It might seem that doing so would guarantee that gains would be taxed at the current rate versus a potentially higher rate in the future. But trading under our approach is limited to occasional rebalancing, so these apparent savings are illusory to the extent that an investor plans to hold these assets, rather than sell them. Selling today would sacrifice 15 percent of any gains with certainty, as well as any future appreciation on that amount that might have otherwise been earned. Harvesting gains in this manner will also increase an investor’s adjustable gross income, which can reduce or eliminate other tax deductions or subject the taxpayer to the Alternative Minimum Tax (AMT). Finally, investors must consider that any trades intended to accelerate taxable gains will result in additional transaction costs.

Planned sales are another matter. Investors sometimes hold risky portfolios that are dominated by one or two securities with a very low cost basis. In these cases we often recommend a deliberate strategy to sell off highly appreciated assets over two or three tax years. Investors who have implemented such plans may wish to accelerate their selling in order to absorb larger-than-planned realized gains this year.

While “harvesting gains” should be avoided, generally, it nevertheless remains very important for investors to manage their taxable gains and losses. Specifically we strongly recommend that investors with taxable accounts take full advantage of tax swapping strategies. We describe this technique in detail in the enclosed article on page 85.

Gold investors with taxable accounts take note: the pending rate increase on realized capital gains changes the calculus when comparing gold mining shares versus gold ETFs as a means of maintaining exposure to gold. Under the existing tax schedule, long term gains on gold mining shares are taxed at a maximum of 15 percent.

But gains on bullion-based ETFs are taxed at 28 percent because the underlying asset, gold, is considered a collectible. Beginning in 2013, however, mining shares will be taxed at a maximum of 23.8 percent (the higher statutory rate of 20 percent plus the 3.8 percent AHCA surtax). In short, the tax
advantage afforded gold mining shares will be diminished.

For investors facing the highest statutory federal income tax rate, taxes on dividend income will nearly triple, from 15 percent to 43.5 percent (the
statutory maximum of 39.6 percent plus the 3.8 percent surcharge). Taxpayers in this situation should review their asset location strategy and if warranted, rearrange their holdings to ensure their dividend-paying securities are held within tax deferred accounts.

Taxpayers who own a traditional IRA, and who have been considering whether to convert all or part of their account to a Roth RIA, might want to act before year-end. Roth IRAs are funded with after-tax income while traditional IRAs are typically funded with pretax income. Earnings in both types of accounts grow tax-deferred. However, while distributions from traditional (pretax funded) IRAs are taxed as ordinary income, Roth distributions are tax-free. Traditional IRA accounts can be converted to Roth accounts, but income taxes must be paid on the amounts converted. Beginning in 2013, for
anyone whose income is currently below but close to the $250,000/$200,000 limit, a conversion that pushes one’s adjusted gross income above the limit could trigger the 3.8 percent surcharge on investment income.

These observations cover only a small slice of potential and scheduled changes. When legislation emerges, we will advise our readers accordingly.

Also in This Issue:

Viatical and Life Settlements: A Murky Market
Tax Swapping Time
A Reader Inquires
The High-Yield Dow Investment Strategy
Recent Market Statistics
The Dow-Jones Industrials Ranked by Yield
Asset Class Investment Vehicles