Wise Wealth Management

Dennis Covington | Principal

Insights on the keys to enjoying a "healthy wealth".

Impact of Changes to Capital Gains and Dividend Tax Rates

September 2008

In 2003 federal capital gains tax rates were reduced from a top rate of 20% to 15% and the tax rate on qualified dividends was lowered from a taxpayer’s marginal income tax rate (which at the time was 38.6% at its highest) to a flat 15%. The tax bills enacting these rates included “sunset provisions” that cause these tax rates to revert to their pre-2003 levels in 2008. The 2008 sunset was extended to 2010 by the Tax Increase Prevention and Reconciliation Act of 2005 just before the Republicans lost control of both houses of Congress.

I believe an increase in capital gains tax rates and dividend rates is inevitable regardless of who wins the election. Senator Obama has strongly supported an increase to at least pre-2003 capital gain and qualified dividend tax rates in several interviews and if Senator McCain were to win the election the likely loss of additional congressional seats currently occupied by Republicans will push Senator McCain to seek compromise on a tax increase. The reality he faces is that if the next Congress does not address these rates they will revert to the pre-2003 rates on December 31, 2010.

Historically, major tax legislation has been adopted the year after a presidential election and all indications are pointing to some changes in tax policy in 2009 regardless of who wins the election. There is no doubt that these changes will impact all investors; what follows below is a question-and-answer section to help you determine the best course of action in light of those impacts:

Should individual investors realize gains now or continue deferring them?
This is a difficult question to answer because that answer is dependant on the client’s goals, risk tolerance and time horizon. For example, clients with long-term investment horizons will have less of an incentive to realize gains now, since the benefits of deferring the tax may overshadow the wealth loss caused by higher tax rates in the future. However, investors with shorter time horizons should consider realizing gains now.

Over the past few years we’ve met many investors who hold a concentrated position (we define it as any position greater than 10% of an investment portfolio) who are hesitant to sell it because of the tax liability. Unfortunately, many of these investors were tech stock investors in 1999-2000 or bank stock investors in 2007-2008. These investors let the “tax tail wag the investment dog”, as we say, and suffered incredible losses as a result. In hindsight, they would have gladly paid the 15% federal capital gains tax. A silver lining to the likely tax increase is that this factor might push some of these concentrated investors to sell those positions to avoid the tax hike, thereby achieving much better diversification in the process.

Will a tax increase and a rush to sell appreciated securities affect the market?
Many investors hypothesize than an increase in capital gains rates will force the sale of appreciated shares prior to the effective increase causing additional downward pressure on stock values. Our research into this area indicates that other historical changes to the capital gain and dividend tax rates have had little impact on aggregate stock market performance. Most academic studies find little evidence that market performance trends one way or another when a capital gains tax rate change is implemented. Below are two interesting tidbits we found in our research:

  • Following the 2003 cut, tax revenues did increase as investors sold shares and paid less tax. At the same time the stock market rallied significantly in 2003 through 2006. But according to a study by the Federal Reserve economists, the stock market increase was not a result of the 2003 tax cut. As the study pointed out, European stocks, which did not benefit from the U.S. tax cut, performed as well as U.S. stocks over the same period. 

  • The impact of a capital gain tax hike is somewhat limited by the fact that only the value of stocks held by individual investors in taxable accounts will be affected. A significant portion of the stock market is held in pension plans, endowments, and individual tax-deferred accounts like 401(k) plans and IRAs.

     Are there other implications to consider?

  • Asset Location – Currently, we place great emphasis on locating assets in accounts that provide the highest after-tax return. We typically allocate fixed-income investments to tax-deferred accounts and domestic stocks to taxable accounts for our clients who own both taxable and tax-deferred accounts. The logic behind this is that any investment income in tax-deferred accounts is taxed at ordinary rates regardless of the type (i.e., interest, dividends or capital gains). By allocating fixed income to tax-deferred accounts we leave more room in the overall portfolio to allocate domestic equities, subject primarily to qualified dividend and capital gain rates, to a client’s taxable accounts thus maximizing their overall tax efficiency. If capital gain and qualified dividend rates increase the impact of asset location is diminished and becomes a less effective strategy. 

  • Tax-deferred investments become more attractive, particularly Roth IRAs and Roth 401ks. A planning opportunity may exist after 2009, owing to the fact that The Pension Protection Act of 2006 repealed the Roth IRA conversion limit, and allows those who convert tax-deferred accounts into Roth IRAs in 2010 to spread the tax liability over two years. More than likely the conversion will be taxed at a higher rate, but the taxpayer’s ability to spread it over two years will make the transaction more bearable. The advantage here is that all future growth will be income tax free and not subject to minimum distribution rules helping you leave more to your heirs.

    Changes to investment tax rates always present challenges for investors, but they present opportunities as well. We will be monitoring the impact of any tax legislation that takes place in 2009 and will be proactive in keeping our clients informed about what our recommendations are in light of it.

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