By Michael Finke, Ph.D., CFP® and Tom Langdon, JD, CFP®
"The only constant is change, continuing change, inevitable
change, that is the dominant factor in society today. No sensible
decision can be made any longer without taking into account not
only the world as it is, but the world as it will be."
- Isaac Asimov, paraphrasing Heraclitus
In 2003, the Jobs Growth and Tax Relief Reconciliation Act (JGTRRA) reduced capital gains tax rates from a top rate of 20 percent to 15 percent, and lowered the tax rate on qualified dividends from a taxpayer's marginal income tax rate to 15 percent. These lower rates on capital gains and dividends were originally scheduled to expire in 2008, but were extended to December 31, 2010 by the Tax Increase Prevention and Reconciliation Act of 2005.
Interestingly, the extension of the favorable tax rate for capital gains and qualified dividends occurred just months before Republicans lost control of both houses of Congress, and the political climate does not seem to be supportive of a further extension of these lower rates. Historically, major tax legislation has been adopted the year after a presidential election campaign, and all indications are pointing to some changes in tax policy after the 2008 election regardless of which candidate wins the White House.
In recent interviews, Barack Obama has strongly supported an increase to at least pre-2003 tax rates and many believe that further Republican congressional losses will push John McCain to compromise on a rate increase. While current law sunsets the current tax rates for tax years beginning after December 31, 2010, it is likely that we will see changes in 2009 when the new Congress and president work on their version of new tax policy. It is wise for financial planners and their clients to consider how to deal with the increasing likelihood that capital gains and dividend taxes will increase next year.
The Good News, Maybe
When capital gains tax rates were reduced in 1997 and 2003, Congress chose not to apply those changes retroactively for the entire year (the effective date of both the 1997 and 2008 legislation was May 6th). For purposes of administrative convenience and fairness to taxpayers, Congress generally does not enact retroactive tax legislation. There are exceptions, however. In the Pension Protection Act of 2006 (which was enacted into law on August 16, 2006), changes to the Kiddie Tax rules, which were designed to raise revenue to offset other tax breaks in the 2006 legislation, were made retroactive to tax years beginning after 2005.
Congress can, if it chooses to, make any tax law changes retroactive. When making major changes in tax policy, however, the past practice of Congress is to make the changes effective on passage, which increases the likelihood that if a tax increase does occur, it will likely happen next May or later, thereby giving planners sufficient warning. What to do with that warning is another matter.
The last significant capital gains tax increase was imposed by The Tax Reform Act of 1986. In anticipation of the increase in capital gains tax rates, realization and recognition of capital gains by taxpayers increased so they could avoid the higher anticipated capital gains tax rates. If capital gains tax rates are increased in 2009, realization and recognition of gains prior to the effective date will likely spike again. Some advisors have already been counseling clients to recognize some capital gains now as a hedge against the possibility of tax rate increases next year. As the political rhetoric in the presidential campaign is indicating, it seems that the likelihood of a tax rate increase on capital gains is increasing. Does this mean that investors will be selling in a depressed market? Not necessarily. Although it is difficult to assess how quickly the market absorbs the likelihood of a tax change, most academic studies find little evidence that the aggregate market shifts strongly one way or another when a capital gains tax rate change is implemented. However, investors do seem to be able to differentiate between the comparative tax winners and tax losers.
Data collected at the time of the capital gains tax increase of 1986 did not show strong aggregate market shifts. The value of high dividend yielding stocks bounced after tax rates on qualified dividends were reduced by as much as 60 percent in 2003 by the Jobs Growth and Tax Relief Reconciliation Act (JGTRRA). Likewise, the price of stocks that paid no dividends jumped in 1997 after the capital gains tax rate was reduced from 28 percent to 20 percent (a 29 percent change). What will happen to high dividend-yielding equities if the special tax rate on qualified dividends sunsets or is repealed, causing the tax rate on dividends to climb to the taxpayer's ordinary marginal income rate (which may be as high as 35 percent currently, but may rise, depending on which candidate wins the White House, to 38 or 39 percent)? Evidence would suggest that dividend-heavy stocks and indices won't do well.
The value of stocks held primarily by individual investors (rather than institutions) will be more sensitive to tax changes. Institutions can follow classical finance theory by seeking to maximize return irrespective of income tax consequences since, for most purposes, investment gains and ordinary income of corporations are taxed at the same income tax rate. Individual investors, who experience different tax rates depending on the classification of their income, cannot afford the luxury of ignoring the possibility of tax changes, and should therefore consider the impact of tax changes on their long-run investment returns when making purchase and sale decisions.
Realizing Gains: Now or Later?
The question of whether an individual should realize gains now or defer them to the future is a difficult one to answer, and is dependant on the client's goals and objectives, risk tolerance, and time horizon. Empirical studies have consistently shown the value of tax deferral. Of course, tax deferral works best when a client has a long investment horizon, can tolerate fluctuations in asset value over time, and anticipates being in a lower tax bracket in retirement. Clients with retirement planning objectives and long-term investment horizons will have less of an incentive to realize gains now, since the benefits of tax deferral may overshadow the wealth loss caused by higher tax rates in the future. Note, however, that the value of tax deferral itself declines with increasing tax rates, since all of the money deferred will be taxed at the marginal tax rate of the investor when withdrawn from the account. If that tax rate is higher, the investor will receive less purchasing power from the deferred account, all else equal.
Investors with shorter time horizons should consider realizing gains now. For example, a 58 year old client with a real estate investment who is approaching retirement, has a large gain in the investment, and had planned on selling the real estate to supplement retirement income may choose to recognize the gain now and save the additional tax that would be assessed if capital gains tax rates increase. Likewise, those selling real estate in the current year who were planning on engaging in a like-kind exchange under I.R.C. §1031 may wish to trigger gain recognition this year to subject the current gain to tax at the current capital gains tax rates. Planners should calculate the value of deferral using the assumptions set forth by the client, and compare it to the impact of realizing the gain and paying the tax currently. In many instances, it will make sense to recognize gains now.
A change in capital gains tax rates may also have an impact on a client's optimal asset allocation. Current asset allocation strategy favors bond investment in sheltered accounts and equity investment in taxable accounts. Assuming that a client has a target asset allocation, placing the bond/fixed income investments in sheltered accounts and equity investments in non-qualified, or taxable, accounts makes sense because bond coupons are taxed at ordinary rates, as are distributions from sheltered accounts. Placing equity investments in sheltered accounts subjects otherwise lower-taxed capital gains to ordinary income tax treatment. While there is no reason to believe that capital gains tax rates will be equal to ordinary income tax rates (although Nobel prize-winning economist Joseph Stiglitz has pushed to equalize income and asset taxes), it may be time for individuals to consider shifting dividend stocks toward sheltered accounts and paying attention to the tax implications of rebalancing and reinvestment strategies now. This may imply that investors (with the appropriate risk tolerance and asset-allocation) will be moving non-qualified funds away from growth and income type mutual funds and toward growth oriented funds, which tend to yield capital gains that will still, hopefully, be taxed at rates lower than ordinary income tax rates. In light of potential investment tax increases, mutual fund managers may also restructure some of their holdings to make their funds more tax efficient for the fund's owners.
There is a silver lining for sheltered-investment accounts: When taxes on investment income are reduced, the required gross rate of return demanded by investors also declines. For example, if an investor requires a return of 12 percent on stocks in a world where capital gains are taxed at 28 percent, the investor may only require a rate of return of 9 percent when taxes are 15 percent. Depending on the marginal income tax rate of the investor, these two scenarios may yield an equivalent after-tax return. When the required rate of return on investments goes down, the price that investors are willing to pay for a stock goes up. This may be one of the explanations for the rise in the equity market after 1997 and 2003-investors no longer required such a high expected rate of return to invest so they bid the price of stock up to their new, higher intrinsic value. When tax rates go up, however, the required rate of return on stocks goes up as well. After the initial shock of depressed stock prices prior to a tax increase, investors in tax-sheltered accounts may benefit from a higher long-run return on equities if the capital gains tax remains at a higher level. What harms the taxable investor may help the sheltered investor. This is, perhaps, a gray lining to an otherwise challenging tax environment for investors.
If capital gains and dividend tax rates increase, and market prices of securities adjust to reflect the higher rate of return expectations held by investors, clients may wish to allocate more of their portfolio toward tax-sheltered investements and away from non-qualified, taxable investments. When the capital gains tax rates decreased in the early 2000s, many individuals reallocated their current investment dollars to taxable accounts, since the tax gap between capital gains and ordinary tax rates was so large (as much as 20 percent from 2003-2008). If capital gains and dividend tax rates increase, the tax gap decreases, increasing the value of tax deferral for those with long time horizons, although some of that accumulation will be shared with the government upon distribution due to potentially higher ordinary income tax rates. Individuals with shorter time horizons may still wish to allocate more of their investment dollars to the taxable portion of their portfolio to take advangage of any tax gap that may be left.
If a silver lining exists for tax-sheltered accounts, a platinum lining exists for Roth IRAs, Roth 401(k)s, and Roth 403(b)s. Like other investment accounts, Roth accounts will experience the initial shock caused by increased required rates of return. However, if the expected rate of return that investors require on investments increases due to tax rate increases, and future growth rates on assets increase accordingly, all of that incremental growth caused by a tax-rate increase will accrue to the benefit of the Roth account owner-none of it need be shared with the government. Over the long run, this has the possibility of significantly increasing the accumulation of those who have their funds allocated to the tax-free Roth accounts.
A Planning Opportunity
A planning opportunity may also be precipitated by a capital gains/dividend tax rate increase in 2009. Beginning for tax years after 2009, the Pension Protection Act of 2006 repealed the Roth IRA conversion limit, and allows those who convert deferred accounts into Roth IRAs in 2010 to spread the tax liability over two years (2010 to 2011). The purpose of repealing the Roth conversion limit was to increase federal revenues in 2010 and 2011. Since Roth conversions will result in increased federal revenue, Congress may decide to leave that part of the law alone next year, thereby allowing taxpayers to convert their deferred funds into tax-free funds. The timing of this conversion opportunity may be ideal. If investment tax rates increase, causing an increase in required rates of return on investments and a commensurate decrease in the value of dividend yielding and capital gain investments, a conversion to a Roth IRA may be completed when asset values are low. The conversion will cause recognition of gain which will presumably be taxed at a higher tax rate, but the taxpayer will be able to spread the gain out over two years, thereby minimizing the cost of the conversion. All future growth, at the higher required rates of return caused by the tax increase, will be income tax free. This may not be Nirvana, but it may be the closest we can get to it under the tax code.
One final impact of a capital gains tax increase may be a positive one. Increases in capital gains tax rates may provide an inducement for more individuals to allocate more of their funds into their home. Like a Roth account, the increase in value of a personal residence that meets the requirements of I.R.C. §121 is tax free, up to $250,000 for single individuals and $500,000 for married individuals filing joint returns. Since an increase in investment tax rates makes tax-free alternatives more attractive, more individuals may wish to reallocate some of their investment asset holdings to real estate (albeit personal use real estate), and perhaps the price of residences will begin to rise. That would be a welcome relief for the sagging real estate market.
A change in our tax system is on the horizon, and while some changes may have a negative impact on the affairs of our clients and ourselves as they stand today, adjusting the way we manage our finances to meet the challenges posed by change can create opportunity. Understanding how potential changes can impact the financial affairs of us and clients is an essential element to seizing opportunity. Sometimes, to sensibly manage our client's financial affairs, and our own, we must be able to make decisions taking into accout the world as it will be.
Michael Finke is associate professor and Ph.D. coordinator in the Division of Personal Financial Planning at Texas Tech University. He can be reached at firstname.lastname@example.org.
Tom Langdon is an associate professor of business law at the Gabelli School of Business, Roger Williams University, and is a principal in Langdon & Langdon Financial Services, LLC, a Connecticut based tax planning and preparation firm.