The Investment Tax Landscape: Countdown to 2013

In December 2010, Congress extended the so-called Bush-era tax cuts by passing the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. However, for investors, the legislation may represent not a pardon but a stay of execution. While it's true that federal tax rates on income, qualifying dividends, and capital gains have been extended through the end of the 2012 tax year, many of the issues that influenced the debate over tax rate extensions will continue to be the subject of heated discussion. As a result, investors have been granted a reprieve while Congress wrestles with those issues. That's time you can use to think about how best to position your portfolio.

The can won't stay kicked down the road forever

Why should you look at the time between now and 2013 as an opportunity? Because the U.S. budget deficit is at levels that both political parties recognize can't be sustained long-term. Even if Congress canagree on budget cuts, the possibility of higher taxes in the future can't be ruled out.

There are several categories of investors who should be paying particular attention to the planning process in the coming years. They include people with investments that have appreciated substantially in value; people who rely on dividends and bonds to provide them with ordinary living expenses; and people who are considering investing in the newly issued stock of a small business.

Capital gains and dividends

The tax cut extensions gave investors who have large unrealized capital gains some breathing room. Rather than a top tax rate of 20%, long-term capital gains will generally continue to be subject to a maximum rate of 15%, and the rate for investors in the lowest two tax brackets will remain at zero. If you own investments that have appreciated substantially in value and that now represent a bigger portion of your portfolio than you'd like, you have another chance to examine whether it makes sense to unwind those investments before the end of 2012. Taxes obviously are only one factor in making such a decision, of course. However, if you've been considering selling an asset anyway, you've got some time to plan and gradually implement a strategy for doing so.

Two points worth remembering: first, unless further action is taken, the top long-term capital gains rate will increase to 20% after 2012 (a top rate of 10% will apply to investors in the 15% tax bracket); and second, even at the increased level, the rates on those gains would still be relatively low. As recently as 1986, under President Ronald Reagan, the Tax Reform Act of 1986 provided for capital gains to be taxed at the same rates as ordinary income, with a top rate of 28%. To paraphrase Mark Twain, no one is safe when Congress is in session, and there's no guarantee that the top capital gains rate after 2012 might not be increased beyond the scheduled 20% maximum.

Qualified dividends will continue to be taxed through 2012 at the long-term capital gains rates rather than as ordinary income, as they were before 2003 and are scheduled to be again beginning in 2013. The higher your tax bracket and the more reliant you are on dividends for your income, the more you should be aware of the potential impact if that income were subject to higher taxes. Again, many factors will affect your decision about the role of dividends in your portfolio, including the potential for higher interest rates in the future. However, doing some "what-if" analysis might be useful.

Taxable vs. tax-free bonds

Taxable bonds typically pay higher interest rates than municipal bonds. However, if you're in a relatively high tax bracket or expect to be in one in the future, munis can potentially offer a better after-tax return. They may be worth a second look between now and 2013, when--separate from any potential increase in federal income tax rates--the unearned income of people making $200,000 a year ($250,000 for couples filing a joint return) is scheduled to be subject to a new 3.8% Medicare contribution tax. Absent further legislative changes, that could make munis even more attractive for affluent investors.

However, as with any investment decision, there are many factors to consider. Local and state governments have come under severe financial constraints in recent years, and though the default rate on muni bonds has historically been low, default by individual governmental bodies is always possible. Also, the legislation that extended the tax cuts did not authorize continued issuance of Build America Bonds (BABs) beyond 2010. During the almost two years BABs were authorized, many local and state governments used them to tap the taxable bond market; that temporarily reduced the issuance of new tax-free munis. However, since BABs can no longer be issued without further authorization from Congress, the supply of new munis may increase, which could affect prices. Finally, interest rates have been at historic lows since the end of 2008; since bond prices move in the opposite direction from their yields, rising interest rates would not be good news for bond prices.

2013 and beyond

The nation's financial pressures will almost certainly mean continued adjustments to the tax code as 2013 approaches. Though there are no guarantees about what will happen when the new provisions expire, investors generally have another chance to fine-tune their planning efforts while taxes remain historically low. If a bird in the hand is worth two in the bush, why not get expert help in taking advantage of the opportunities available now?

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2011

College Costs Keep On Climbing

As federal and state budgets continue to shrink due to falling revenues and lawmakers attempts to reign in deficits and spending, the fallout is being increasingly absorbed by current and future college students and their families as they try to deal with the skyrocketing costs of post-secondary education around the country.

Two recent reports from the College Board Advocacy & Policy Center, Trends in College Pricing 2011 and Trends in Student Aid 2011 detail the rapid rise in tuition costs for the nation’s two- and four-year public, private and for-profit colleges and universities. The headline of the report is an 8.3% increase nationally in tuition and fees at public four-year colleges and universities (a 4.5% increase at private four-year colleges) between 2010-2011 and 2011-2012. The report also breaks out the increase state-by-state, however, and to no one’s surprise, California lead the way in tuition and fee increases during the same period.

“California, which enrolls about 10 percent of the nation’s full-time public four-year college students, had the highest percentage increase in published in-state tuition and fees (21 percent) for that sector in 2011-12.”

Those numbers are causing sticker shock to the millions of families trying to cope with current costs or plan for the future, and causing them and their financial advisors to completely re-evaluate their projections. And while the costs continue to rise, it has not become a deterrent for enrollment. Total post-secondary enrollment increased by about 22 percent between 2005-06 and 2010-11 according to the reports as young people clearly realize the importance of a college degree as it relates to future earnings power.

“While the importance of a college degree has never been greater, its rapidly rising price is an overwhelming obstacle to many students and families,” said College Board President Gaston Caperton. “Making matters worse is the variability of price from state to state.”

In California, already one of the nation’s most expensive states to attend college, a recent budget proposal by University of California officials is calling for steep rate increases of up to 16% per year over the next four years if the state doesn’t increase funding to the U.C system. According to a recent Associated Press report,  “In July, UC officials approved a 9.8 percent tuition increase for the current school year -- on top of a previously approved 8 percent -- after the state reduced UC funding by $650 million, or about 20 percent. The system could lose another $100 million if the state generates less revenue than anticipated.”(Chea)¹. While the regents have not yet taken action on the newest proposed increases, unless greater funding can be obtained from the state, which seems unlikely, it is hard to imagine that further large-scale increases will not be implemented.

It is important to understand that while the percentage increases in tuition and fees are eye-popping, the published charges are not always an accurate indicator of the actual total costs of attending various universities. The price variability of additional costs such as room and board, is often magnified due to the difference in cost of living from region to region. According to a recent article in the Daily Californian, “Although UC Berkeley’s in-state tuition and fees — which were $8,353 in 2009-10 — are the lowest of all the UC campuses with the exception of UCLA, the high cost of living in the Bay Area makes the total cost for students much higher. According to estimates from the report, the total cost of attending UC Berkeley in 2009-10 was $28,312.” (Bickham)².

Students are increasingly forced to make tough budgetary decisions in the face of these additional costs in an effort to control their total debt obligations once they have finished school. One of our interns from U.C Berkeley recently explained the measures she and some of her classmates have made to this end: “…on-campus student housing has gotten so expensive, that for this year, 5 of us got together and found a one bedroom apartment to share which costs less than half of what we would be paying for student housing”.

Students are making these kinds of decisions because they are keenly aware that there is no guarantee of a good-paying job waiting for them once they graduate with their degree in-hand. “In the current economic climate, recent college graduates who borrowed for their education face particular challenges in paying back their student loans. The unemployment rate for young college graduates rose from 8.7 percent in 2009 to 9.1 percent in 2010, the highest annual rate on record.”(Reed)³. These numbers closely mirror the current national averages for unemployment which is surprising given that unemployment among college graduates has traditionally been considerably lower than the national average.

The rapidly rising prices of college tuition coupled with the deterioration of the labor market following the recent deep recession have contributed to soaring American student debt, which, by some estimates, now exceeds a trillion dollars and is larger than total US credit card debt. It is no wonder that among current students who are absorbing these higher costs, and recent graduates facing the realities of a stagnant job market, frustration is mounting. The huge debt burdens and the inability to service them are among the main undercurrents of the ‘Occupy’ movements around the country, and the recent clashes on college campuses highlight the growing concerns surrounding them.

Despite the fact that the state and federal governments have slashed funding for public higher education and all indications are that trend will continue for the foreseeable future, they have at least tried to provide some small amount of relief by way of tax credits and continued favorable tax treatment of certain college savings vehicles such as 529 plans. These measures are small consolation however for the growing numbers of over-leveraged, under-employed young people entering the workforce each year fresh out of America’s colleges and universities.

So what does all of this mean for the millions of families that are trying to save for future college costs? Certainly, the importance of a college degree is as great as ever, even if it doesn’t grant the holder an automatic path to financial freedom. Increasingly, we are seeing parents using these current conditions as a teaching moment for their children on the importance of financial literacy and the value of saving. Providing guidance and incentives for children to learn to budget and save for their own educations can have a lasting effect in preparing them for their post-education lives. As always, careful planning and saving are the keys to success, and the earlier the better.

¹ Chea, Terence. "UC Tuition Could Nearly Double Under Budget Plan." Huff Post Los Angeles 09 Sept 2011. n. pag. Web. 16 Sept. 2011

² Bickham, Travis. "UC Berkeley student loan debt less than nation’s average." Daily Californian 07 Nov 2011. n. pag. Web. 9 Nov. 2011

³ Reed, Matthew, Lauren Asher, Pauline Abernathy, Diane Cheng, Debbie Frankle Cochrane, and Laura Szabo-Kubitz. "Student Debt and the Class of 2010." Project on Student Debt. The Institute for College Access and Success, Nov 2011. Web. 9 Nov 2011.