Rising Capital Gains Tax Hurts Everyone

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Because of Obamacare and the failure of Congress to extend current tax rates, capital gains taxes will soon rise from 15% to 23.8%. Take note, take heed, and take action.

The tax increases will come in two stages, starting with a hike in 2011 from 15% to 20%. The 15% rate, established in the 2003 tax cuts, will expire at the end of this year. This is part of a more extensive rise in taxes taking effect January 1, 2011.

Another capital gains tax hike was part of the Democrats’ healthcare bill. It adds an additional 3.8% tax on long-term capital gains and dividends beginning in 2013.

Combined, these two tax increases enact a 59% increase in the capital gains tax rate. That’s a huge tax increase, and taxes affect behavior.

The optimum rate for capital gains taxes is zero. Every economist worth his Ph.D. agrees that the correct rate for the capital gains tax is zero, zip, nada. Some have even suggested the optimum tax rate for capital gains is negative!

We should be rewarding saving and investing because it builds an enduring and robust economy. Saving is currently too low.

We need incentives to save and invest and thus create an economic environment that encourages the hard work and risk taking that pays everyone’s salary. Investment is simply capital, and capital is simply deferred consumption. Why defer consumption if you are penalized for it?

Investment supports the factories, businesses and entrepreneurial ventures that actually make money. It stimulates the economy, which then creates jobs and produces real wealth.

The prospects for our Social Security system look bleak. There won’t be enough money to support the number of retirees. Chances are only the worst off will receive anything significant from current funding. And now the political winds are blowing to make saving and investing for your own retirement much more difficult. It seems as though “fair” is being redefined to impoverish everyone and force them to rely on the government.

The new rate for capital gains will leave very little reason for anyone to take the risks associated with capital investments. With an average inflation rate of 4.5% and an average return of 11%, the return may not be worth the risk. Politicians are giving us no incentive to take care of ourselves. They are ensuring that government will need to save us.

For example, imagine you assume the risk and invest $100,000 in an equity venture. Let’s suppose the investment pays off and appreciates 8%, or $8,000 in a year. Under the new rates, you would owe $1,904 in capital gains tax. And $4,500 of your remaining profit would simply be inflation on which you still have to pay taxes.

You would be left with only $1,596 of real return after inflation, a pitiful 1.6% gain over inflation. With such a small reward for taking risk in capital ventures, why not simply invest in municipal bonds with a guaranteed return and no taxes due?

Of course investing in municipal bonds may have its own risks. Downgrades or even defaults in muni bonds may make that category suffer its own poor returns. And if you lend money to spendthrift government entities, you may not even get your principal back.

The effect of higher capital gains taxes on investments is immediate and devastating. Capital investments make innovation and new businesses possible. Plans for such ventures include five-year return on investment projections that now have to take into account the headwind of a punitive government taxation environment.

Few will see these negative results because they are entrepreneurial plans that won’t happen. People have a hard time seeing what doesn’t happen. But the result will be that American-style 6.5% growth will slow to a more European-style 4% growth. Every 1% less you get on your investments over your career means you will have to work an additional seven years to attain the same lifestyle in retirement.

Big government politicians will ultimately blame all of these harmful effects on the markets themselves. They will use it as a populist excuse for higher taxes and more regulation. Their policies will have taken all the gains, and in the end they will try to take the credit for saving us.

Henry Hazlitt, in his well-known book “Economics in One Lesson,” lamented, “The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.” Unfortunately, voters rarely pay attention long enough to connect the dots on the unintended consequences of economic policy.

In the meantime you should make some changes in your portfolio this year. Your retirement may depend on it.

First, if you are wealthy and haven’t done Roth conversions yet, get them done before the end of the year. Pay as much tax as possible at the current tax rates and transfer your traditional IRA investments into a Roth account where the capital gains rate is zero.

Going forward, only investments in a Roth will have a tax rate that is most favorable to market risk and return.

Second, for your taxable investments, ensure your portfolio will be able to weather a long period of unfavorable capital gains taxation. If you have banked a large amount of capital losses, this may be sufficient. Otherwise you may want to cash in all your unrealized capital gains and pay the current 15% rate. Then order your portfolio so you won’t have to make many significant changes over the next few years.

A well-structured portfolio may be able to avoid realizing any capital gains during the remainder of the Obama administration. Waiting for a more favorable administration is a wise strategy.

For taxable accounts, you need to be in control of when you realize capital gains. This is most easily accomplished when you are invested in exchange-traded funds (ETFs) rather than mutual funds that kick off capital gains as the fund manager makes trades in the underlying portfolio.

ETFs are very tax efficient. They seek to minimize capital gains by exchanging those stocks sold out of the index for those funds added to the index. Because buying and selling in the fund is done by means of like-kind exchanges, it is not a taxable event. Hence with ETFs no capital gains are owed until you decide to sell.

If you invest in individual stocks, there quickly comes a time when the company should be sold and your profit taken. By buying the right mix of ETFs, you will be able to hold the index indefinitely. And by structuring your portfolio across your taxable investments and your traditional and Roth accounts, you will be able to rebalance your portfolio outside of your taxable account.

A well-structured asset allocation should be able to weather a poorly run administration. And whenever voters realize they can’t soak the rich without drying up the capital that drives prosperity, the capital gains rate will be lowered or, in the best case scenario, eliminated entirely.

Photo by Ryoji Iwata on Unsplash

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David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.