Strategies for Uncertain Tax Rates
Thursday, September 20, 2012
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Capital Pains: Rules for Capital Losses
Excess losses can be used against future earnings.

2011 Tax Guide
Useful information about 2012 and potential 2013 taxes.

AAII Discussion Boards
Are you making changes in anticipation of the fiscal cliff?

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 37.5%, up up 1.0 points
  Neutral: 28.7%, down 1.8 points
  Bearish: 33.8%, up 0.8 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »


With the tax breaks about to expire and automatic spending cuts set to kick in, the House of Representatives is ending its session without preventing either from occuring. Late last week, House Majority Leader Eric Cantor announced, "We no longer anticipate votes in the House during the week of Oct. 1. This is a change from the original House calendar.” It is probable that the Senate will also break without passing related legislation.

This leaves the issue of avoiding the so-called fiscal cliff up to the post-election session of Congress, where some members will be lame ducks. Though the focus of the November elections is the presidential race, many House and Senate seats are also being contested. Several combinations could potentially result from the elections, making it completely unclear what will actually happen.

It seems logical that there will be tremendous pressure on lawmakers to do something. I’m not a political scientist and I’m certainly not going to attempt to predict what will or won’t happen in the lame duck session. As an investor, I would be cautious about making an investment decision based on Washington. There are penalties for both guessing wrong about the likelihood of a positive outcome (a practical agreement in Congress) and a negative outcome (the fiscal cliff occurs).

This is why you should focus only on what you can control. Here are some suggestions for those of you in the current 25% or higher income tax brackets.

Capital Gains and Losses: Long-term capital gains tax rates could rise to 20% next year. If this increase occurs, realized losses will be more valuable. (You will be able to reduce your tax bill more next year). While you should not hold onto a bad investment in hopes of getting a bigger tax break next year, you should be aware that excess net losses can be carried forward. Realized, allowable net losses in excess of $3,000 of ordinary income can be carried forward to use on next year’s taxes. If you have unrealized gains, you should let the attractiveness of the investment and your strategy dictate whether to take profits now or in the future, not the prevailing tax rate.

Dividends: Taxes on qualified dividends could change from 15% to ordinary income tax rates. Combined with expiring breaks on ordinary income tax rates, those in the highest bracket could see dividends taxed at 39.6%. Plus, married couples with adjusted earnings above $250,000 will have to pay an additional 3.8% because of a new Medicare tax. These taxes can be avoided by holding dividend-paying stocks in a tax-deferred account, such as an IRA or a Roth IRA.

It should be pointed out that more than 400 members of the S&P 500 currently pay a dividend. So any broad-based backlash would impact most large-cap stocks. Furthermore, a note put out by Fidelity Investments yesterday estimates that the most affluent taxpayers only received 3.3% of their total income from dividends.

Municipal Bonds: Municipal bond interest is generally exempt from federal taxes and some state and local taxes as well. This characteristic boosts the aftertax realized yield. Plus, muni bond interest is excluded from next year’s new Medicare tax. If you need portfolio income, muni bonds are worth considering. Keep in mind, however, that when interest rates do rise, the value of existing bonds will decline.

AMT and Estate Tax: Both the alternative minimum tax and the estate tax are scheduled to reset next year. If either could affect you, consider sitting down with a tax professional now to determine what your current options are.

Use All of Your Accounts: If you have both taxable accounts and IRAs, use both to your advantage. Hold your most tax-efficient assets (e.g., muni bonds, index funds, etc.) in your taxable accounts. Use your IRA, and your Roth IRA, to hold your less-tax-efficient assets (e.g., dividend-paying stocks). Doing so keeps taxable events away from the prying hands of the IRS. It’s a good strategy to follow, even when you know what tax rates will be in the future.

More on AAII.com

AAII Model Portfolios Updated

CONN’S Inc. (CONN) was sold from the Model Shadow Stock portfolio for violating the size limitations. The proceeds were used to buy three holdings: Hardinge (HDNG), Olympic Steel (ZEUS) and Renewable Energy Group (REGI).

Last month, the Model Shadow Stock Portfolio gained 9.1%, outperforming both the Vanguard Small Cap Index fund (NAESX), which gained 3.5%, and the DFA US Micro Cap Index fund (DFSCX), which gained 3.1%. For the year, the Shadow Stock Portfolio is now up 18.9%, outpacing the 11.8% gain achieved by the Vanguard Small Cap Index fund and a 10.6% gain for the DFA US Micro Cap Index fund.

The Model Fund Portfolio was up 3.1% for August. This compares to a 2.5% gain for the Vanguard Total Stock Market Index fund (VTSMX). For the year, the Model Fund Portfolio is up 9.1%, while the Vanguard Total Stock Market Index fund is up 13.2%.

The Week Ahead

We will continue to see early third-quarter earnings reports. S&P 500 member companies announcing results next week include Lennar Corp. (LEN), Paychex (PAYX) and Red Hat (RHT) on Monday; Carnival Corp. (CCL) and Jabil Circuit (JBL) on Tuesday; Accenture (ACN), Discover Financial Services (DFS), McCormick & Company (MKC) and Nike (NKE) on Thursday; and Walgreens Company (WAG) on Friday.

The week’s first economic reports of note will be the Conference Board’s September consumer confidence survey and the July S&P Case-Shiller housing price index, both of which will be published on Tuesday. Wednesday will feature August new home sales. The final estimate of second-quarter GDP, August durable goods orders and August pending home sales will be published on Thursday. Friday will feature August personal income and spending, the final September University of Michigan consumer confidence survey and the September Chicago PMI.

The only Federal Reserve official scheduled to speak will be San Francisco Federal Reserve Bank President John Williams, on Monday.

The Treasury Department will auction $35 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

AAII Sentiment Survey

Bullish sentiment rose to a four-week high, while bearish sentiment rebounded to a eight-week high in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 1.0 percentage points to 37.5%. This puts optimism at a four-week high. Nonetheless, bullish sentiment is below its historical average of 39% for the fourth consecutive week and the 24th out of the past 25.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 1.8 percentage points to 28.7%. This is a 12-week low for neutral sentiment. The historical average is 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 0.8 percentage points to 33.8%. This is the highest level of pessimism registered by our survey since August 2, 2012. Bearish sentiment is also above its historical average of 30% for the 20th time in the past 24 weeks.

Individual investor optimism remains improved relative to what was registered throughout spring and much of the summer. While pessimism is persistently staying above average, it is below the May through July readings. Splitting the moods of AAII members are higher stock prices, improved economic data, slowing global economic growth, Washington politics and the European sovereign debt crisis.

This week’s special question asked AAII members how last week’s announcement of more monetary stimulus by the Federal Open Market Committee impacted their sentiment toward stocks. There was not a consensus among our members. More than a third of respondents said the move will help stocks. Another 10% thought the move would provide a temporary lift to stocks. Conversely, nearly 30% said the announcement didn’t change their sentiment. Some members described the move as being bad for the U.S., while others viewed gold as now being more attractive.

Here is a sampling of the responses:

  • “I will be moving more assets out of cash and into stocks.”
  • “The announcement reaffirmed that fixed income will not satisfy my retirement income needs and an overweight commitment to equities must be maintained.”
  • “Short term, I feel somewhat more positive about stocks, but I am equally wary of the downside risks of stimulus.”
  • “It doesn’t impact my sentiment toward stocks at all. Although, I don’t believe more monetary stimulus will accomplish much of anything.”
  • “It hasn’t affected my sentiment because I’m awaiting for the November election results.”
  • “The Fed’s policy is a disaster. We will get bitten by it sooner or later.”


» Take the sentiment survey

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor