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Maneuvers to Make on Your Way to the Fiscal Cliff

Stocks in this article: MORN

NEW YORK ( BankingMyWay) -- Barring a sweep by one party or the other, one key matter will not be resolved Election Day: the looming "fiscal cliff," set to usher in higher tax rates in January. Deciding what to do about that automatic repeal of the Bush-era tax cuts will involve some tough negotiations, and a stalemate would present millions with higher taxes on income, capital gains and dividends.

With the fourth quarter about to begin, this uncertainty makes year-end tax moves especially important this year, says Christine Benz, director of personal finance for Morningstar (MORN), the market-data firm. Writing on the Morningstar website, she suggests that investors go against their instincts and consider selling some winning investments to benefit from today's historically low tax rates.

If Washington doesn't act, the capital gains rate for assets owned longer than a year will rise to 20% from today's 15% for those in higher tax brackets. People in the 15% income tax bracket will pay a 10% long-term gains rate instead of zero. Income tax rates are also set to go up across the board -- to 39.6% from 35% for those in the highest bracket, for instance. Dividends will be taxed as income, losing the low 15% cap they've enjoyed for the past decade.

A key step, says Benz: Think about rebalancing your mix between stocks, bonds and cash, a move many people think about in January when year-end statements make it easy to assess gains and losses. U.S. stocks have had a very good year, and bonds and foreign stocks did better than most analysts had expected, Benz notes.

"Given that run-up, it's a decent time to take stock of where your portfolio is today," she says. "And this year, it's particularly important to conduct your year-end checkup before the year is actually over."

She observes that a portfolio that was 50/50 stocks and bonds in early 2009 would now be 63/37. An investor who had let rebalancing slide would therefore be shouldering more risk today than intended. But rather than simply restoring the intended mix, Benz suggests that investors rethink their allocations. That's because a big bond allocation may be less appealing now that yields are so low and there's a risk of bond prices falling if rates rise.

Investors should also rethink their handling of dividend-paying stocks, as annual taxes on dividends could more than double for those in higher brackets. The bill can be postponed, giving dividend payers more time to compound if those stocks are held in tax-deferred accounts such as 401(k)s and traditional IRAs. Under the current rules, this has not been a particularly attractive strategy, because dividends were taxed at 15% in taxable accounts but potentially at higher income-tax rates when eventually withdrawn from tax-deferred accounts. But if the higher rates return in January, dividends will be taxed as income in both types of accounts, so investors might as well postpone the bills by sheltering dividend payers in tax-deferred accounts.

Of course, selling dividend-paying stocks in taxable accounts and buying them in tax-deferred accounts could trigger capital gains taxes, complicating the decision.

Finally, Benz suggests investors think about converting their tax-deferred traditional IRAs to tax-free Roth IRAs. Unfortunately, a conversion triggers an income tax on gains, interest earnings and dividends that have not been taxed previously. But it might be better to face those taxes this year, when rates are low, than to face higher tax rates on future withdrawals, should the Bush rates be allowed to expire.

As you see, every move involves tradeoffs. That's why thinking about it now could put you in a good position to move quickly before the end of the year. Hopefully, Washington will iron this out after the election but before Jan. 1, making it a bit easier to devise the best strategy.

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