Investing in Real Estate Through Mutual Funds - T. Rowe Price

Understanding the New Tax Landscape

What do the changes in tax rates mean for investors?

Following the tax legislation signed into law on January 2, 2013 ("American Taxpayer Relief Act"), investors can begin to assess how the tax rate changes may affect them. All workers have seen a drop in their take-home pay due to the end of the two-year payroll tax break, as the Social Security withholding rate returned to 6.2% from 4.2%. However, single filers with ordinary income up to $400,000 and married couples filing jointly with income up to $450,000 will experience no change in ordinary income tax rates, and long-term capital gains and qualified dividend tax rates are unchanged at these income levels.

With the settling of the tax debate, you can now focus your attention on fundamentals that will help you achieve your financial goals. "Taxes are just one part of the picture," says Judith Ward, CFP®, a senior financial planner with T. Rowe Price. "The most successful approach is to save for your goals; diversify your investments with an appropriate mix of stock, bond, and short-term holdings; and use the best types of accounts for each objective."

Tax-advantaged accounts such as Traditional 401(k)s and Traditional IRAs allow you to make pretax contributions that can reduce your taxable income while saving money for retirement. In these accounts, your money remains tax-deferred, and your savings are included as taxable income only when you withdraw them in retirement. You also may have the option to contribute to a Roth account within your 401(k), if offered by your employer's retirement plan, or a Roth IRA, if you fall within the income requirements. Roth contributions do not reduce your taxable income today; however, any earnings on these contributions are tax-deferred, and any qualified distributions are completely tax-free. Explains Ward, "Most investors understandably focus on the tax break they may get today because it's more tangible, and they may not realize that their withdrawals from tax-deferred accounts later in life will be taxed. A Roth account offers a great way to diversify your retirement tax situation."

With the new tax law, investors with access to a Roth option within their 401(k) plan may now convert the savings in their Traditional 401(k) to the Roth account. Keep in mind that funds converted to a Roth account are subject to income taxes at the time of conversion.

Investors in high marginal income brackets—33%, 35%, and the new top rate of 39.6%—may consider applying tax-minimization strategies for investments in taxable accounts that produce taxable income, dividends, and capital gains in taxable accounts. Some tax-efficient mutual funds, for example, attempt to minimize capital gain and dividend distributions to shareholders. Also, municipal bond funds, which provide income exempt from federal taxes—and, in some cases, state taxes—could be even more appealing now.

These kinds of strategies may be particularly useful for investors with investment income that exceeds the threshold amounts of $250,000 for married couples filing jointly and $200,000 for single taxpayers. Beginning in 2013, these individuals may be subject to a 3.8% tax on net investment income, which includes dividends, interest, and capital gains (net of certain expenses and capital loss offsets). The tax is paid on the lesser of the total net investment income or the amount of modified adjusted gross income (MAGI) in excess of the income threshold.

Gift and estate taxes. The top marginal estate and gift tax rate increased to 40%, and the unified lifetime estate and gift tax exclusion amount was made permanent. The individual exemption is $5.25 million for 2013 and will be indexed for inflation thereafter. And estate tax "portability"—the ability to add any unused portion of the deceased spouse's estate tax exemption to the surviving spouse's exemption amount—has become permanent.

Alternative minimum tax (AMT). The alternative minimum tax was never indexed for inflation. The result was that an increasing number of middle-class taxpayers became subject to the AMT, prompting Congress to "patch" the AMT each year. The new tax law permanently indexes AMT for inflation.

Qualified charitable distributions. Traditional IRAs require investors to begin taking distributions from the account by April 1 of the year after they reach age 70½.

A provision in the tax law allows individuals age 70½ or older to make tax-free distributions of up to $100,000 directly to charity in 2013, enabling them to avoid having to include the distribution amount in their taxable income in 2013.

It is important to understand the implications of the new tax landscape on your financial situation. But, says Ward, taxes alone should never drive your investment decisions. "Certainly take taxes into account as you work toward your goals," she says. "But they should be just one facet of a holistic approach to your financial and investment strategy."

A Look at the 2013 Tax Numbers

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6 What do the changes in tax rates mean for investors?
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