October 2010 - Personal Planning

There has certainly been a great deal of uncertainty affecting the financial markets this year—driven by everything from anxiously awaited economic data to all kinds of major issues involving taxation, legislation, and regulation. On top of all of this it is an election year. Indeed, some have referred to this as a period of unusual uncertainty, and markets do not like uncertainty—not even usual uncertainty! Even critical estate planning issues, including tax rates that apply to gifts and inheritances, that most experts felt sure would be addressed by Congress last year, are still being neglected and have fallen into limbo — and may still remain unresolved at year’s end. In turn, this high degree of uncertainty across the board on so many important matters has led to substantial volatility throughout the year. One item that many investors are still worrying about is whether income tax rates will increase in 2011, perhaps significantly, and whether this could adversely affect asset prices.

QuoteIf higher tax rates on dividends, interest, and realized capital gains should occur—which is currently the default next year if Congress does nothing—then some wonder if stocks in particular should be avoided because of the higher potential cost of ownership. Stocks, however, are typically leading indicators that anticipate events six to nine months in advance. Therefore, it is possible that the stock market has already discounted the probability of higher tax rates next year—and perhaps some of the selling that has already occurred this year has been due to investors taking advantage of current lower relative tax rates. By the same logic, it stands to reason that in 2011 there could be fewer investors willing to sell because it will be more expensive to do so, and if there are ultimately fewer sellers there might be less downward pressure on prices. If so, this might possibly coincide with more buyers willing to come off the sidelines if economic data improves. There is currently over $2 trillion held in cash that could return to the capital markets at some point, and more buyers than sellers usually results in rising prices.

Of course, we are not making this prediction per se, but rather suggesting that there is this potential flip side to the argument about higher tax rates that causes some investors such concern right now. There is also a partial silver-lining in any tax increase scenario for those investors who might have capital loss carry-forwards from previous years—since those losses would essentially become more valuable as potential offsets to future gains that would otherwise get taxed at higher rates. Another interesting tax related consideration in 2010, depending upon various circumstances, is the Roth IRA conversion. Generally speaking, the Roth conversion does not make sense for people who are likely to need the value of their existing traditional IRA to meet their own needs in their lifetimes. The conversion also does not make much sense for charitably-inclined people who might earmark some or all of their required minimum distributions (RMD) to qualified non-profit organizations. However, the provision for people over age 70 ½ that permits this transfer of up to $100,000 of annual RMD directly to charity—thus avoiding personal taxation on the withdrawal —might not be extended in 2011 or beyond. And yet, IRA owners can still designate charities to be the beneficiaries of their IRA’s, and if this is the plan then the Roth conversion does not make sense.

For others, though, who might want to use an IRA to help meet their bequest to family—and who have sufficient non-IRA assets to pay the upfront conversion tax—the Roth IRA might be attractive. Personal income tax rates are currently at multi-generational lows, and are likely to rise in coming years as Congress is forced to deal with the ever-increasing
national debt. It could be that the tax rate applied to any full or partial conversion now is lower than the rate that eventually gets applied to future withdrawals. Moreover, Roth IRA’s do not have mandatory distributions for either the life of the owner or the spousal beneficiary, so they can conceivably grow untouched for much longer than traditional IRA’s; and when withdrawals are required of the next generation they are completely tax-free. Traditional IRA’s only grow tax-deferred and any and all withdrawals (except the charitable option described above) are taxed at prevailing ordinary income tax rates in the year in which they are received. As always, everyone’s situation is unique and requires close individual analysis; but these might be worthwhile considerations to examine before year-end.