Prepare Your Portfolio Now for Tax Code Changes

By Eric Henderson of Nationwide Financial

COLUMBUS, Ohio ( TheStreet) -- No one knows for sure how the tax code will ultimately look in the next year, but we know the tax code will change. Bush-era tax cuts are set to expire at the end of 2013, and if our lawmakers take no action we can expect higher estate, investment and income taxes. In a lame duck congressional session, it's unclear what actions lawmakers will take before the end of the year.

That's why it's a great time to meet with a financial adviser to begin formulating a plan to ensure your portfolio is prepared for the changes to come. You won't find an adviser who knows exactly how things are going to play out, but a good one can help you understand the three most likely potential tax change scenarios:
  • Tax rates will increase, particularly for the wealthy.
  • Tax deductions will be reduced.
  • Tax rates will decrease, but tax preferences are removed.

Despite a lack of clarity on which scenario may finally materialize, there are several actions worth considering that may put your portfolio in a better position for an uncertain future. Some opportunities may disappear when current tax laws expire, so don't wait until next year.

When you sit down with your financial adviser, be sure you ask him or her about the three types of taxes that are likely to change: investment taxes, income taxes and estate taxes, and how they may affect your portfolio.

Investment taxes: Starting next year, tax on dividend income is set to increase from 15% to ordinary income rates as high as 39.6%. Long-term capital gains rates are scheduled to rise from 15% to 20% for most taxpayers. Those with high overall income and investment earnings should plan for an additional 3.8% Medicare investment earnings surtax.

Ask your adviser:
  • Should I consider selling large stock or mutual fund positions this year to generate a capital gain at the current rate?
  • If so, can I reinvest the proceeds from these sales in a more tax-efficient manner or in a tax-deferred vehicle?
  • Should I consider converting funds or investments that are taxable (for instance, bank CDs, money market accounts, mutual funds and other vehicles that result in annual taxable income) into tax-deferred opportunities such as tax-free municipal bonds, tax-deferred annuities or life insurance?
  • Should I adjust my dividend stock position?

Income taxes: Bush-era tax cuts expire at the end of this year. This will affect the top four marginal brackets and eliminate the 10% bracket, resulting in higher taxes for nearly everybody unless there's a political solution. Also next year, the phase-out of itemized deductions for high-income earners is set to return.

Ask your adviser:
  • Should I take advantage of current low income tax rates by accelerating income such as bonuses, receivables and associated deductions into the current tax year?
  • Is this a good time for me to fund a Roth 401(k) or Roth IRA?
  • Should I consider converting traditional IRA assets to a Roth IRA now?
  • Are there opportunities for me to maximize my deductible retirement plan contributions in 2013?
  • Does it make sense for me to shift assets from taxable accounts to a deferred variable annuity to gain tax deferral?
  • Should I roll assets from a 401(k) to an IRA to gain access to mutual fund strategies that may not be available in a 401(k)?

If you're owner of a pass-through entity such as an S Corp, partnership or LLC you may also want to ask whether it makes sense to accelerate receivables into the current year.

Gift and estate taxes: If you're concerned about passing significant assets to your heirs, you should take note that the gift and estate tax exemption is scheduled to shrink from $5.12 million to $1 million, creating potentially significant new tax exposure for many.

Ask your adviser:
  • Should I set up an irrevocable life insurance trust before current exemption levels expire?
  • If so, does it make sense to buy an annuity inside the trust to pay premiums on the life policy?

A critical component of the conversation with your financial adviser should focus on your tax diversification strategy. This means allocating a portfolio to assets that are taxable now, later or may never be taxed. You may be able to avoid a worst-case scenario by placing your investment eggs in more than one tax basket.

As you can see, there are many portfolio adjustments worth considering -- some of which may make sense for your portfolio, some may not. That's why the time is now to sit down with a good financial adviser who understands you and your goals. Don't wait for laws to change and potential opportunities to expire before having this critically important conversation.

Eric Henderson, FSA, MAAA, is senior vice president of individual products and solutions for Nationwide Financial (NFS). Nationwide does not provide tax advice. Tax advice should be sought from a tax professional such as a CPA.