Investment Tax Rates (on Capital Gains and Stock Dividend) are Set to Rise Significantly in 2013

Currently, the maximum tax rate on investments sold at a profit after more than a one year holding period is set at 15 percent. This long-term capital gains tax rate, as well as the tax rate on stock dividends, are scheduled to increase and dramatically so in 2013.

Part of the increase is already a done deal per the terms of the federal health care bills (also known as Obamacare) passed in 2010 (details below). Another portion of the increase will occur due to the expiration of 2003 tax cuts in effect through the end of 2012.

Whether you plan on selling any investments over the next couple of years or not, you should understand what's going and what could change because these tax rates could have an important impact on financial markets and the U.S. economy.

Increased 2013 Investment Taxes from Obamacare

Taxpayers with total taxable income above $200,000 (single return) or $250,000 (joint return) from any source will be subject to a 3.8% extra tax on the lesser of:

• Their net investment income (e.g., interest, dividends, capital gains)
• The amount, if any, by which their modified adjusted gross income exceeds the dollar thresholds

(Net investment income excludes distributions from qualified plans).

From the perspective of the financial markets, a concern about higher taxes is a possible negative impact on investments. The 3.8 percent increased tax on investment income is potentially more concerning when considered on top of the increased taxes coming with the expiration of the 2003 tax cuts at the end of 2012.

The current 15 percent tax rate on long-term capital gains and dividends on stock for higher income investors is scheduled to increase back to 20 percent in 2013. When combined with the new 3.8 percent tax from the health care bill, this would produce a top long-term capital gains and stock dividend tax rate of nearly 24 percent - a significant increase from the current 15 percent level.

How are higher income investors likely to respond to that large an increase by 2013? A 24 percent rate is about the average of the past 50+ years so it's not out of line in that regard. And, 24 percent would still be well below the highest marginal income tax rate (which should be about in the high 30s) so moderate and higher income investors will still benefit from long-term capital gains tax treatment versus regularly taxed earned and investment income such as from a taxable bond. The time periods with a similar long-term capital gains tax demonstrate that the U.S. stock market performed fine.

However, it is interesting to note and not surprising that increases in the capital gains tax rate coincided with reduced government tax revenue from that tax. This happens because investors realize and see the impending tax hike and take more capital gains when rates are relatively low and they are expected to increase (like the period we are now in). Also, once rates rise, investors who are able to hold off on realizing capital gains until some future year when rates may be lower.

Obama Just Said He Would Raise Minimum Tax Rate to 30 Percent

While a jump from 15 percent to 24 percent is a significant increase, in his recently completed State of the Union address, President Obama said that according to his so-called "Buffett Rule," folks earning more than one million dollars a year should be paying at least a 30 percent tax rate.  

Frankly, this statement surprised me and isn't welcome news in the financial markets. I have no idea where Mr. Obama got 30 percent from. And, his choice of 30 percent contradicts numerous statements he and his economic advisors have made in prior interviews and articles where 20 percent was the more commonly cited number.

For example, in an August 14, 2008 op-ed for the Wall Street Journal, two of then Senator Obama's economic advisors, Jason Furman and Austan Goolsbee, stated the following in their summary of proposed tax law changes that Obama would pursue if elected President:

"The top capital-gains rate for families making more than $250,000 would return to 20%...The tax rate on dividends would also be 20% for families making more than $250,000, rather than returning to the ordinary income rate..."

What's Likely to Happen to Future Investment Income Tax Rates

Tax reform is long overdue and might finally happen in 2013. The specifics of tax reform very much hinge upon the outcome of the November, 2012 national election.

I have ranked from most probable to least probable the expected outcome of the election and what happens to the tax rate on investment income:

• Republicans control two of the three branches (Senate, House, and Presidency) of government and do not allow any further increases in tax rates on investment income. The only tax increases which stick will be those in Obamacare. The only other tax "increases" which might pass are the taking away of some special deductions (broadening of the tax base) through tax reform which broadly lowers rates. This would be quite good for financial markets and the economy.  
• Republicans control all three branches. The tax increases scheduled to take effect in 2013 with Obamacare will be rolled back and no others will occur. If Romney wins the Presidency, he has proposed eliminating investment taxes for folks making less than $200,000 per year. The financial markets would like this.
• Democrats control two of the three branches (as they do now). The Obamacare tax increases will be locked in and more (although not large) increases could hit upper income folks depending upon the make-up of Congress and how tax reform negotiations progress. Expect a luke-warm response at best from the financial markets.
• Democrats control all three branches. There is almost no chance that this scenario will occur. But, if it does, as with the passage of Obamacare, Mr. Obama will get his way and significantly increase the investment tax on higher income earners. Unfortunately, the much needed tax reform is unlikely to pass (just as it hasn't even been proposed the past three years). The U.S. financial markets and U.S. economy will languish.