Will the Capital Gains Tax Rate Change After the Election?
The political conventions are over and now begins the real speculation about how the electoral votes will add up in November. While the political pundits debate who will win the White House, it’s certain that tax and fiscal policy will loom large for the next president’s domestic policy agenda. No matter who wins, there’s likely to be change, especially with the capital gains rate.
Currently, the top rate on long-term capital gains—the profitable sale of stocks, bonds, mutual fund shares, and other securities or assets held for more than one year—is 15 percent. The Democratic nominee, Sen. Barack Obama, D-Ill., says he would raise the top 15 percent capital gains rate, perhaps as high as 25 percent. On the Republican side, Sen. John McCain, R-Ariz., says he wants to keep the current capital gains rates steady. However, capital gains rates likely will increase regardless of who wins the presidential election. That’s because if Congress takes no action, the current tax laws are set to expire in December 2010, increasing the top capital gains rate to 20 percent in 2011.
Remember, in 2003 the Jobs Growth and Tax Relief Reconciliation Act reduced capital gains tax rates from a top rate of 20 percent to 15 percent, and it 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 originally were scheduled to expire in 2008, but were extended to December 31, 2010, by the Tax Increase Prevention and Reconciliation Act of 2005.
(If you’re interested in the history of the capital gains tax in America, visit the web site of The Tax Policy Center, a joint venture of the Urban Institute and the Brookings Institution, and read Preferential Capital Gains Tax Rates by Deborah Kobes and Leonard E. Burman. Among the facts cited that provide an historical perspective for possible increases is the Tax Reform Act of 1969, phased in from 1970 to 1976, which made the maximum tax rate on capital gains 49 percent, the highest level since 1921.)
Perhaps more important than how much the capital gains rate could increase is the question of whether the tax hike could lead to a stock sell-off over the next year or so as investors seek to lock in a lower tax rate. While that could result in a further slide in a market already down over 20 percent from last fall’s high, any potential downturn likely will be temporary. Notably, when Congress raised the capital gains rate to 28 percent in 1987, the stock market indexes dropped briefly before recovering and moving ahead roughly at the same rate they had been advancing prior to the increase. In fact, some economists anticipate that the increased Federal revenue resulting from the sell-off would lower the Federal budget deficit, providing just the shot in the arm the market needs to get moving.
Just who will be affected by a capital gains tax increase? Interestingly, a July 2008 study, Who Pays Capital Gains Tax?, by Eric Toder and published by the Urban Institute,found in 2006 just 13.4 million out of 138.3 million taxpayers reported taxable net gains on Schedule D. (These are net long-term gains in excess of net short-term capital losses and capital gains distributions, which are taxed at favorable capital gains rates.) Another 4.6 million reported capital gains distributions from mutual funds on their Forms 1040.
According to Toder, many taxpayers with gains had modest incomes; 52 percent of those with taxable net gains or capital gains distributions had incomes below $75,000. However, high-income taxpayers accounted for the overwhelming share of capital gains. The 3 percent of tax returns with an adjusted gross income (AGI) exceeding $200,000 reported 31 percent of AGI and 83 percent of capital gains. The 0.3 percent of returns with an AGI exceeding $1 million reported 15 percent of AGI and 61 percent of capital gains. Capital gains represented less than 4 percent of AGI for gains recipients with income less than $200,000, but about 40 percent of AGI for those with income exceeding $1 million.
Obviously, many more Americans accrue capital gains on corporate shares they hold in tax-deferred, employer-sponsored retirement saving plans or individual retirement accounts. But, remember that capital gains from stock sales within those accounts are not subject to capital gains tax. Assets in those accounts grow tax-deferred, and distributions are then taxed as ordinary income.
So, with a little more than a two-year window to take advantage of the current 15 percent capital gains rate, what should you do? As always, the decision to sell investments or defer your gains to the future should be informed by your goals, risk tolerance, and time horizon. Naturally, tax deferral works best when you combine a long investment horizon with high-risk tolerance and anticipate lower tax rates in the future. If you have a relatively short time horizon, you might consider realizing gains now. If, for example, you have a highly appreciated real estate or art investment that you’re counting on to supplement your retirement income stream, now may be a good time to recognize the gain and save the additional tax that would be assessed if the capital gains tax rates were to increase. What’s more, if you’re planning to sell appreciated real estate this year and engage in a 1031 Exchange, you may instead wish to trigger your gains so they are subject to the current 15 percent capital gains tax rate.
In either case, we’d be happy to help you look at a variety of possible scenarios and calculate the projected value of deferral versus the impact of realizing the gain and paying the capital gains tax now. As always, the overriding factor in your sell decision should be whether the investment is the right one, given the long-term role it plays in your portfolio. That can only be ascertained on a case-by-case basis; there are no general rules-of-thumb. As the old investment adage insists, it’s imperative not to let the tax tail wag the dog. However, with change looming on the horizon, we remain dedicated to staying on top of changes to the tax law so you can make necessary portfolio moves, plan for the future, and take advantage of any new opportunities