The Taxman Cometh

By Matt Malick and Ben Atwater

Bob Dylan wrote, “You don’t need a weatherman; to know which way the wind blows.” With an annual federal deficit of over $1 trillion, total national debt north of $16 trillion, the reelection of President Barack Obama, and the heated debate over the “fiscal cliff,” it is clear that taxes will rise in 2013 and beyond.

The pressing questions now: how much and in what manner?  Another question, more pertinent to us, is what effect will an increase in tax rates have on the stock market?

Let’s begin by looking at the two most important tax rates for stock investors – qualified dividends and long-term capital gains.  Current law has the tax on qualified dividends rising from 15% to 39.6% - a tremendous increase that would dramatically damage what investors earn on a net basis.

However, the good news is that even President Obama’s proposed budget only taxes qualified dividends at 20%, so it is highly unlikely that the tax on qualified dividends will be more than 20% for an extended period.  If the President and Congress don’t reach a deal on the fiscal cliff, rates will technically rise to 39.6% for a short time.  But, as 2013 progresses and politicians reach a compromise, we do not believe that anyone will pay more than 20% on qualified dividends when they file their 2013 tax returns.

As for long-term capital gains taxes, current law has this rate increasing to 20% from 15%.

One caveat to all of this is a new tax that will take effect in 2013 to fund the Patient Protection and Affordable Care Act (Obamacare), a Health Insurance High Income tax / surcharge.  With the reelection of President Obama, we must assume that Congress cannot repeal this legislation.  Therefore, beginning in 2013 the federal government will assess an additional 3.8% tax / surcharge on net investment income – dividends, interest and capital gains.  This tax applies to filers with joint adjusted gross income of $250,000 or more and individuals with $200,000 or more.

While a 3.8% additional tax on high income investors is not entirely trivial, we do not believe an investor would ignore otherwise profitable investments just to avoid this tax.  For example, a $10,000 investment in a stock yielding 4% would go from generating $340 (15% dividend tax) in after-tax income to $304.80 (20% dividend tax + 3.8% “Obamacare” tax).  In a world of near-zero interest rates, this is still an attractive yield.  And a comparison of after-tax capital gains would produce similar results.

So, the question that investors should focus on is not necessarily how much taxes will be, but what kind of value do the underlying investments offer.  As you well know, we have been arguing for several years that stocks offer a compelling long-term value.  If you can make solid profits on your underlying investment, should you really lose that much sleep over a 15% versus a 20% or 23.8% capital gains tax?  In our opinion, the current uncertainty about taxes is causing much more angst than the actual tax increases that are likely to take effect.

It is also vital to remember that many mass affluent investors own most of their marketable securities in tax-deferred accounts like IRA Rollovers, 401(k) plans, Roth IRAs, etc.  Capital gains and dividends that investors earn within these vehicles are not taxed at the time they occur, rendering the increase in dividend and capital gains taxes a moot point.

Tax-deferred accounts are a good transition to marginal tax rates, which are set to increase with the fiscal cliff and will likely rise for high income earners even as part of a compromise that allows most of the Bush-era tax cuts to remain in place.  When retirees pull money from tax-deferred accounts, they pay ordinary income tax rates.

Presently, the highest marginal tax rate is 35% and it is set to increase, under current law, to 39.6%.  If you are married and filing jointly, you need to earn $388,350 before you pay a dollar of taxes at the 35% rate.  If you are single, you need to earn $178,650.

Not only do rates rise under current law, but high income earners also face an additional 0.9% Medicare tax / surcharge on wages above $200,000.  This is another provision of the Patient Protection and Affordable Care Act.

So, what is someone to do between now and year-end?  The vast majority of people should probably do nothing.  However, some folks may want to chat with their accountant, attorney and investment advisor.

First, if you own a stock with very significant unrealized long-term capital gains, and you are content with the appreciation you have achieved, then it might make sense to liquidate the stock now.  But, before you do that, consider what you are going to do with the proceeds because the opportunity cost of selling a long-term holding simply to pay 5% less in capital gains tax might ultimately bite more than the tax ever would.

Second, if you are a high income earner with lots of vested stock options, then you might seek to exercise your options in 2012 because next year you will pay a higher marginal income tax rate and many of the options you exercise are likely to be taxed at your marginal rate.

And finally, although we haven’t talked about the estate tax, it is also set for major changes, though uncertainty around the estate tax will probably persist throughout 2013.  If you have a total net worth greater than $5 million and you haven’t reviewed your planning in a few years, we would recommend that you run to your estate planning attorney – preferably today.