Capital Gains Under Threat Again

05/03/2012 10:30 am EST

Focus: MARKETS

Charles Carlson

Editor, DRIP Investor

Politicians that are more concerned with staying in office than fixing the republic are once again forced to deal with important questions about tax fairness...so what will they do, asks Charles Carlson of DRIP Investor.

Since 2003, investors have paid a maximum tax rate of 15% on dividends (as well as long-term capital gains) as a result of what are referred to as the “Bush tax cuts.”

You may recall that this rate was set to expire at the end of 2010. In August 2010, I made the case that if the maximum 15% tax rate on dividends were left to expire, investors would see a huge jump in their tax rates on dividends.

Indeed, investors in the top tax bracket would lose roughly 40 cents out of every dollar in dividends. That amounted to nearly three times the current amount, or a tax increase of 164%!

Fortunately, the tax cuts were extended for two years, but are now set to expire at the end of 2012. Thus, in the immortal words of that noted market prognosticator, Yogi Berra, “It’s déjà vu all over again.”

Indeed, investors are now facing the same uncertainty that gripped the market in 2010—will the Bush tax cuts expire at the end of 2012, or be extended, or (better still) made permanent?

How that question is resolved could have huge ramifications for all investors, not just the “1% crowd.” According to Internal Revenue Service data, 69% of people who reported qualified dividends on their tax returns in 2009 earned less than $100,000; 23% earned less than $25,000.

There has been discussion that the tax rate should be left to rise only on the “wealthiest” households, those with adjusted gross incomes of more than, say, $250,000.

However, such a modification—or even an extension of the rate for all investors—would seemingly require political bipartisanship (that is, of course, unless one party captures the White House and both houses of Congress, an unlikely event, in my opinion). And bipartisanship has not exactly been the modus operandi in Washington these days.

Now, I don’t want to turn this into a political column. This newsletter is not about espousing a particular political agenda. It’s about making money for its readers. But as I stated then, sometimes the goal of making money runs up against political forces that make the job a lot tougher for investors.

A 164% tax increase on dividends—actually, if you include the new Medicare tax on investment income, the effective tax rate on dividends for high earners would increase approximately 190%—would certainly be a major obstacle for investors, especially DRIP investors who favor dividend-paying stocks.

Why are higher taxes on investments bad for your investment portfolios? Simple math. If you boost taxes on dividends and capital gains, you reduce after-tax returns. And when you reduce expected after-tax returns, asset values have to adjust downward.

Sure, people can roll out studies and timelines that show that an increase in investment taxes didn’t adversely impact market returns in the past. These studies usually point out periods that stocks actually rose when investment taxes increased. My argument would be that the higher taxes didn’t aid those returns, but actually limited what would have been even greater investment gains.

The word “fairness” has become a lightning rod in public discourse. What is a “fair” tax policy? Who should pay their “fair share” of taxes?

I’d like to lob one more log on the “fairness” fire—is it fair that there are any taxes on dividends? After all, dividends are already taxed at the corporate level in the form of profits. That means investors who pay any tax on dividends—even one as “low” as 15%—are paying the second round of taxes on dividends.

Is the double taxation of dividends “fair?” Is increasing the amount of that double taxation by raising the tax rate on dividends, even to the wealthy, truly “fair?"

Elections have consequences, and the outcome of this November’s elections could have a huge impact on how your investment portfolios are taxed going forward. Don’t sit idle. Contact your representatives and let them know where you stand on higher taxes on dividends. And tell a friend and family member to do so, too.

For more information on this topic, a useful Web site is www.defendmydividend.org. At the Web site, you’ll find an “Act Now!” link on the right-hand side of the home page. Click on that link, fill out a simple form, and send a message to the senators and congressman from your state saying you want to see the current tax rates extended.

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