Investment US Tax Changes for 2011

Disclaimer: I am not a Certified Public Accountant (CPA), tax advisor or tax lawyer. Please talk with your CPA, tax advisor, or tax lawyer before making any investment decisions that may have tax consequences for your investments. One of my investment rules is know the tax consequences of any investment that you plan to make before you make it and make it tax efficient, whether under current tax laws or forecasted future tax changes. Taxes and/or government fees will be increasing over the next 5 years to help pay for the federal, state and local government deficits and future government entitlement programs (for example, health care).

Former president Bush’s tax cuts will expire at the end of 2010 and revert to the previous tax code for long-term capital gains, qualified dividends, revival of the estate tax and adding back the top marginal bracket of 39.6% at the beginning of 2011. As of today Congress has not addressed the expiration of these tax cuts. The following are my predictions for 2011:

Long-term capital gains tax (on assets held longer than one year): Currently 0% for taxpayers in the 10% and 15% tax brackets as of 2008 and 15% for everybody else, it is scheduled to return to the pre-BTC (Bush’s tax cuts) rates of 10% for 15% and below brackets and 20% for everybody else. I predict congress will not take action on the tax bracket above 15%, effectively making the long term capital gains tax 20%; they may take action to set the tax rate at 5% for the 15% and under tax bracket.

Qualified dividends: In 2011 qualifying dividends will go back to their pre-BTC rate i.e. ordinary income based on your highest tax bracket. Bush’s tax cut of 2003 changed the qualified dividends tax rate from ordinary income (your highest income tax bracket) to the same as capital gains (15% for most people). Your tax rate could be high as 39.6% if you are a high income earner. Congress could change it to be the same as long-term capital gains – 20% for most taxpayers – but I think it’s more likely they will not take action and it will return to your ordinary income rate of your highest tax bracket.

Top income tax bracket: Bush tax cuts eliminated the top income tax bracket of 39.6% and created a new 10% bracket for low income earners. If Congress does not take action, the top income tax bracket in 2011 will be 39.6% and the 10% bracket will be eliminated. I predict Congress will let the top bracket tax rate go to 39.6% and will take action to keep the 10% tax bracket.

Revival of the estate tax: In 2010 there is no limit on the size of your estate that is not subject to federal estate taxes unless Congress takes action this year and sets a limit on the estate size that is tax exempt. Starting in 2011, unless Congress takes action, the federal estate will go back to the pre-BTC exemption of $1,000,000 with a maximum tax rate of 50%. This is one of the tax increases that Congress may act on and set the exemption at $3,000,000.

The two tax changes that will have the greatest effect on investors will be the increase in long-term capital gains and qualified dividends tax rates. The dividend tax rate will more than double for taxpayers having income over $141,000 and married filing jointly (it will go from 15% to 31%). I always try to have all my interest and dividend paying and non tax efficient taxable investments in my non-taxable accounts (for example, IRAs and 401 accounts). This is the reason why I have not invested in mutual funds in my taxable accounts for the last five years; Exchange Traded Funds (ETFs) are much more tax efficient than mutual funds (if you are interested please read my blog - BRIC ETFs and ETFs vs. Mutual Funds). This will become more important starting in 2011 unless Congress acts to decrease long-term capital gains and qualified dividends tax rates. This strategy will also help high income earners and investors that will be in the 39.6% bracket – they will not have to pay almost 40% in taxes on their interest and dividends returns to the federal government.

With all of the House of Representatives and 1/3 of senators up for reelection in November 2010, a lot could change in 2011 for investment tax rates. My strategy is always to have interest- and dividend-paying and non tax efficient investments in my non-taxable accounts. Also, any investments for which there is a high degree of difficulty determining the tax liability, i.e. trading stocks, future contracts, exotic ETFs, etc., are invested in my non-taxable accounts.

Please chime in with your comments on 2011 tax rates, tax efficient investments, or anything else.

© 2010

Paul Cusick