Preparing for Tax Hikes

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Harvest Tax Losses Now

In order to pay taxes, you need to make money—and, if a big payday means a big tax bill, maybe that's a good problem to have in a time when many people are losing their jobs.

Still, no one likes paying extra to Uncle Sam. And, Blain says, "when you're talking about a higher-income person, it makes a huge difference." Some wealthy Americans, after all, could see some income taxed at a rate of almost 40% under Obama's tax plan.

Whether taxes are headed higher in 2009 or not, many advisers suggest investors harvest tax losses before the end of the year. Capital gains taxes take a bite out of your gains, but the opposite—losses—can help minimize tax bills. Under the capital-gains tax, "the government essentially takes on part of the risk involved in equities," Blain says. The government "can finance part of your loss."

Which Account is Right?

So, with the stock market and other investments down substantially for the year, investors can sell investments and realize a loss that might be used to offset income elsewhere this year or in future years. One complication: IRS rules often prohibit buying back the same investment right away, so you might need to find a similar investment to replace the one you sold.

To prepare for higher taxes over the longer term, investors can carefully choose which investments are placed in tax-protected accounts, such as 401(k) plans and traditional individual retirement accounts (IRAs), and which are in taxable accounts. For example, gains and dividends from stocks are typically taxed under the capital-gains rate. For wealthy investors, this rate is lower than their regular income rate, even if the rate rises from 15% to 20%, as Obama has proposed. Therefore, it might be smart to put equities or tax-protected municipal bonds in a taxable account. Meanwhile, real estate funds or other bonds—the proceeds of which are usually taxed as regular income— might go in tax-protected accounts.

If you think tax rates are going higher, you might prefer to pay taxes now rather than later. Some planners advise moving investments from traditional IRAs (in which you pay taxes when you withdraw assets from the account) to Roth IRAs (in which you pay taxes when you deposit assets). However, these strategies are not right for all investors, and their suitability depends in part on what tax rate you expect to be paying during retirement. Accountants and financial planners can help do that complicated math.

One Last Chance

The tax threat is a hot topic in financial planning offices these days. Many advisers predict more demand for complicated tax protection schemes, including trusts, variable annuities, and life insurance plans. Sometimes these options come with high price tags in terms of fees and commissions, so it's important to get impartial advice, Rogers says. "People need to be thoughtful and not get seduced by the sales pitch," he says.

The last two months of 2008 give investors one last chance to make tax moves before possible increases in 2009. But it's important not to make any foolish decisions you might regret. Make sure you actually would be affected by the proposed tax increases, and wait until legislation is passed before making any moves you can't reverse. Seek professional help for the more complicated tax planning calculations.

Most important of all, advisers say, don't make investing decisions solely based on their tax implications. Remember that the goal of investing is to make money, not just to avoid taxes.

Steverman is a reporter for BusinessWeek's Investing channel.