The Trouble With Taxes

11/26/2012


Count me among the millions of investors frustrated with the market's recent weakness.

The S&P 500 Index has fallen nearly 4% since the end of September, with all 10 sector indexes down. At times like this, it can be hard to hold, and even harder to buy.

Of course, you can always find reasons not to invest. And in recent months a new worry has surged to the forefront: the looming tax hike on capital gains and dividends. A number of stocks with big gains in recent years, such as Apple ($566; AAPL), have pulled back sharply. Is it reasonable to expect such stocks to bounce back? Or is it time to sell?

Tax hikes loom

President Obama has proposed several changes to tax rates for Americans in the top two income-tax brackets, as outlined in the table below. Politicians could still work out a compromise to mitigate some of the increases. But until then, expect stocks to react to the market's worries about tax hikes.

HERE COMES THE TAXMAN
Prior to his re-election, President Obama proposed letting ordinary tax rates revert to pre-2003 levels for the highest two income-tax brackets. Taxes on capital gains and dividends would also return to former levels for high-income taxpayers, plus an additional 3.8% from the Affordable Care Act. Obama also plans to eliminate a provision that reduced the capital-gains rate to 18% on assets held for more than five years by high-income taxpayers.
---- Tax On Ordinary Income ----
Tax On
-- Capital Gains --
Tax On Dividends
Ordinary Income
Bracket (Married
Couples Filing Jointly)
2012 With
Bush-Era Tax
Cuts In Place
(%)
Administration's
2013 Budget
Proposal
(%)
2012
(%)
2013
Proposal
(%)
2012
(%)
2013
Proposal
(%)
$0 to $71,000
Same (10% to 15%)
0
0
0
0
$71,001 to
$241,900
Same (25% to 33%)
15
15
15
15
$241,901 to
$390,050
33
36
15
23.8
15
39.8
Above $390,050
35
39.6
15
23.8
15
43.4
Source: Urban-Brookings Tax Policy Center.

Higher expected tax rates could spark the inverse of typical year-end behavior, with investors dumping winners, rather than losers, before the end of 2012. For those already planning to sell a stock soon, it could make sense to capture gains during this tax year. Investors who want to pay taxes at today's rates but would like to keep owning the stocks can purchase new shares after they sell the old ones, resetting their cost basis at today's prices.

The proposed tax hike could also suppress investors' appetite for dividend stocks. The Obama administration's 2013 budget proposal would require upper-income investors to pay taxes on dividends at ordinary-income rates. Since the Nov. 6 election, the median S&P 500 Index stock has delivered a loss of 2.9%, roughly equal to the return of the median stock yielding at least 3%. But high-yielders have delivered a median loss of 5.1% since the end of September, versus a 4.0% loss for the median stock in the index.

Divining a single explanation for the stock market's reaction can be dangerous. The stock market is a giant discounting machine that continually crunches the odds of dozens and dozens of events occurring. The S&P 500's recent sell-off also reflects weak September-quarter results and disappointing outlooks for many U.S. companies, continued troubles in Europe, and growing doubt that U.S. lawmakers can avert the confluence of expiring tax cuts and automatic spending cuts set to begin on Jan. 1.

That brings us back to the stock market. Yes, there are reasons to worry. Yes, stocks could fall further. But no, we do not advise wholesale selling. Unless you are a high-tax-bracket investor who has been planning to sell a stock anyway, you should base your investment decision on the stock's operational health and valuation — not a change in the U.S. tax code.


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