Wealth Matters: Taxes Influence Investment Strategy, and Not Always for the Better

That may not be a good thing for their portfolios.

“Clients are definitely asking, because it’s a real issue in today’s environment,” Michael N. Bapis, a managing director and partner with the Bapis Group at HighTower Advisors, said. “We try to keep them focused on the goals — preserving what they have, capturing some of the upside, limiting the downside. At the end of the day, we can’t change the tax laws.”

When asked about how tax rates would affect an investment, he said his advice was almost always the same. “If it doesn’t make sense for your portfolio, then it doesn’t make sense,” he said, even if there is tax savings. “If it does make sense, regardless of the tax consequences, we’re going to put it in your portfolio.”

Last week, I looked at how the changes to the tax code were affecting how people thought about their estate plan. This week, I’m looking at how tax increases can influence people’s investing behavior.

The tax rates on investments have increased significantly from last year. Depending on a person’s income, taxes on long-term capital gains and dividends are now as high as 23.8 percent, an increase of 59 percent over last year’s rate. Taxes on investments that are held for less than a year that incur short-term capital gains tax or investments subject to income tax rates have increased for top earners by 24 percent, to 43.4 percent (with the Medicare surtax included) from 35 percent.

Those are substantial increases, but focusing on them alone can obscure a fuller analysis of risk. Investors can end up paying no taxes on an investment, but that may be because they lost money on it, or they may pay lots of taxes on a large gain that they might not have achieved otherwise. This is why advisers stress that taxes should not be the first concern when deciding whether to buy — or not buy — an investment.

If there is one investment that has been promoted as great for minimizing taxes and achieving a large gain, it is master limited partnerships. Most are involved in the transportation or storage of oil and natural gas. What makes them appealing, from a tax perspective, is that a large portion of the dividend they pay is treated as a return of principal and is not taxed.

But in the rush for one type of tax savings, investors can end up paying other taxes. Master limited partnerships with pipelines that run through several states can incur state tax bills for investors, though usually only when the income goes above a certain threshold.

The bigger tax concern generally comes when investors sell their partnerships, since the part of the dividend that was not taxed for years reduces the original price of the investment. Greg Reid, a managing director at Salient Partners and chief executive of the firm’s $18 billion master limited partnership business, said an investor who bought a partnership and sold it five to 10 years later could be faced with two types of taxes. The first is income tax, because the original purchase price would have been reduced by the amount of principal returned in the dividends. The second is capital gains tax on the increase in the value of the investment itself.

Another way to look at these partnerships is to consider the solid and increasing dividends they have paid over the last 25 years, often 6 to 7 percent.

“The baby boomers are going to need a lot of income to live,” Mr. Reid said. “M.L.P.’s are particularly great for older people who are retiring. They have a growing income stream.”

As for avoiding high taxes, the solution is to give the partnership to charity or die with it in your estate. Both may be viable options for investors in their 70s and 80s but are probably less attractive to people in their 30s.

Municipal bonds, which have long been attractive to wealthier investors because the interest they pay is not taxed by the federal government, pose a different sort of risk.

Mr. Bapis said he was concerned that investors who were not paying attention to the broader economic news were not aware of the current risks of buying an existing municipal bond. With yields on many municipal bonds extremely low — around 0.75 percent for five-year bonds and 1.74 percent for 10-year bonds, according to Bloomberg — even a small increase in their price, which would cause the yield to go down, would cause a loss of principal.

Article source: http://www.nytimes.com/2013/05/04/your-money/taxes/taxes-influence-investment-strategy-and-not-always-for-the-better.html?partner=rss&emc=rss