July 16, 2010

By Judith Ward 

A wide variety of tax cuts, originally enacted in 2001 and 2003, are slated to expire in 2011. How might these changes affect you?

The package of tax cuts that will expire in 2011 (assuming Congress doesn't step in) includes a mix of income and investment-related tax rates. On the income side of the ledger, tax rates in effect before 2001 would return. Generally, this means taxes are going up for higher income individuals, though the impact would vary depending on your income level. Investors may also be affected by the following:

• Long-term capital gains rates for those in the highest tax brackets are expected to increase from their current cap of 15% to 20%.
• Qualified dividends would be taxed at ordinary income rates rather than today's more favorable rates.

Ordinary Income			Capital Gains
2010	2011 if Congress does not act	2011 Current budget proposal+	2010*	2011**
10%	15%	10%	0%	10.0%
15%	15%	15%
25%	28%	25%	15%	20.0%
28%	31%	28%
33%	36%	36%
35%	39.6%	39.6%

Note that dividends have generally been taxed at regular income tax rates for many years; the "qualified" dividend rate was a creation of the 2003 tax law. It allowed the more-favorable rates shown here specifically for longer-term investments in U.S. corporations. One thing that will not change: Short-term capital gains will still be taxed at your ordinary income tax rate.

While tax considerations shouldn't drive portfolio decisions, they can play a role in planning.

Just as investment diversification can help you weather uncertainty in the markets, tax diversification can help you weather the uncertainty of future tax rates. It is important to have a mix of taxable, tax-deferred, and tax-free accounts to provide flexibility for your future savings and income needs. You can read a detailed explanation of tax diversification strategies in Investor magazine.

As tax rates increase, the value of tax-advantaged accounts becomes even greater. In general, the more tax-advantaged accounts you can incorporate into your portfolio, the greater the potential for long-term compounded growth.

If you are in a higher tax bracket or think you may be moving into one, consider investments with unique tax benefits or tax-managed strategies. These might include:

• Tax-free bond funds. Tax-free, or municipal, bond funds offer income that is exempt from federal taxes and, in some cases, state and local taxes as well. Tax-free bonds typically offer relatively low yields but because of the tax savings they provide, many investors in higher tax brackets receive higher after-tax income than they would in a taxable bond fund.
  
  See how taxable and tax-free yields compare based on your situation. Some income may be subject to the federal alternative minimum tax.
• Tax-efficient stock funds. If you're concerned about capital gain distributions, consider stock funds that are managed to reduce taxable distributions. You could also consider index funds. By the nature of their passive management, index funds tend to have lower turnover, which typically means lower taxable distributions. All funds are subject to market risk, including possible loss of principal.

Keep in mind that long-term capital gains rates, though rising, are still more favorable than ordinary income tax rates. Depending on your situation, it may be helpful to seek advice from a tax professional to fully understand your potential tax liabilities.

With a little planning and some helpful choices, you may not only be better prepared for impending tax changes, you may also be able to build a stronger portfolio that limits long-term tax costs and provides flexibility for your future financial planning.