Municipal bond and other tax-exempt investing strategies may gather more money as wealthy U.S. investors respond to higher tax rates approved by Congress this week.
“The bad news is rates are going up,” said Gary Schatsky, president of New York-based financial advisory ObjectiveAdvice.com and a past chairman of the National Association of Personal Financial Advisors. “The good news is it could have been much worse for people in higher tax brackets, and there are things you can do about it.”
The budget deal passed by Congress on New Year’s Day raises the capital gains and dividends taxes to 20 percent from 15 percent for individuals earning more than $400,000 and couples earning more than $450,000. The 2010 health-care law also tacks a 3.8 percent surcharge on net investment income for singles earning above $200,000 and for couples above $250,000, starting this year.
Investors seeking shelter from taxes are likely to turn increasingly to municipal bonds, index-based funds and tax-managed mutual funds, wealth advisers said. They shouldn’t abandon dividend-paying equities and high-yield bonds, but concentrate those in tax-deferred retirement vehicles to avoid the blow, according to Schatsky.
Municipal bonds in the U.S. have long offered returns exempt from federal and most state taxes as a way of encouraging investment in public development projects.
The $3.7 trillion market earned 7.3 percent in 2012, compared with 2.2 percent for U.S. Treasuries, according to Bank of America Merrill Lynch data. Muni-bond funds got about $51 billion in deposits last year, the most since 2009, according to Investment Company Institute estimates.
“Higher marginal rates for at least some investors, along with little prospect of changes to municipal bonds’ tax status, makes munis even more attractive on an after-tax basis,” Russ Koesterich, BlackRock Inc.’s global chief investment strategist, wrote in a Jan. 2 note. New York-based BlackRock, with $3.67 trillion in assets as of Sept. 30, is the world’s biggest money manager.
Firms including Eaton Vance Corp. and Fidelity Investments, both based in Boston, offer mutual funds designed to minimize capital-gains taxes for investors, typically by turning over holdings relatively rarely. When a manager sells a stock at a profit, the fund records a capital gain that must be distributed to shareholders at year’s end.
The after-tax advantage of index mutual funds and exchange-traded funds, which tend to turn over their holdings less frequently than actively run funds, will be greater now for the same reasons, said Fran Kinniry, a principal in the investment strategy group at Valley Forge, Pennsylvania-based Vanguard Group Inc., the largest U.S. mutual-fund firm.
Even if some investments are becoming less attractive from a tax standpoint, that doesn’t mean the wealthy need to reduce their allocation in those areas, according to Laura Scharr-Bykowsky, a financial planner in Columbia, South Carolina, who oversees $50 million in client assets. High earners typically have assets in tax-deferred retirement plans as well as in taxable accounts, Scharr-Bykowsky said.
Investors should think about keeping passive mutual funds and ETFs in taxable accounts while putting investments such as real estate investment trusts, high-yield bonds and dividend-paying funds in tax-protected retirement accounts.
People can use investments in other ways to lower their tax bills. When clients of ObjectiveAdvice.com’s Schatsky want to make a sizable charitable donation, he suggests they donate securities that have gone up in value instead of writing a check.
“If you give $10,000 in Apple stock that you bought for $5,000, you still get to take a $10,000 deduction and don’t have to pay capital gains on the $5,000,” he said.
Advisers caution against becoming too fixated on taxes.
“There are big benefits to being tax-efficient, no matter what,” said George Padula, an adviser in Boston with Modera Wealth Management LLC, which oversees about $1 billion. “But you have to make sure you’re making the right decisions for the long run, and taxes are just one part of that issue.”
U.S. tax rates “didn’t move up a whole lot” under the budget deal, said Todd Jones, director of investments at Gratus Capital Management, an Atlanta-based firm that oversees about $600 million.
“We are back to the historical norms that existed in the 1990s,” Jones said.