By Lauren Foster
President Barack Obama swept to victory on Tuesday, securing four more years in the White House. Now what? What does the outcome mean for taxable investors, and what should you and your clients be thinking about between now and the end of the year?
To learn some of the answers, I checked in with Robert N. Gordon, founder and president of Twenty-First Securities Corporation, adjunct professor at NYU, and coauthor of Wall Street Secrets for Tax-Efficient Investing: From Tax Pain to Investment Gain.
But first, a quick recap of where things stand: Congress has less than eight weeks until the U.S. economy heads over the so-called “fiscal cliff,” the scheduled series of mandated tax increases and spending cuts that go into effect in January 2013. While capital gains and dividend tax rates have not received as much attention as other aspects, both are scheduled to rise at the end of the year based on current law — along with the rates on ordinary income, interest, gift, and estate taxes. (See “Countdown to a Tax Hike.”)
Are We Headed Over The Fiscal Cliff?
Gordon is in the camp that believes we don’t need a parachute, we probably aren’t going over the edge.
“Even though there may be gridlock, no one really wants us to go over this fiscal cliff, and there are certain things that both sides agree on,” he said. “Both sides agree that the Bush tax cuts should be extended to people who earn less than $250,000, and the only thing they disagree on is what happens to people who make more than $250,000.”
Moreover, he added, “Both sides agree that the way you raise money is not by increasing tax rates but by somehow limiting deductions. So I think what is going to happen is that they are going to put a Band-Aid on for about six months, and I think the President has sort of signaled he would be willing to have one of these bridges as long as they put a down payment on, and I think what you’ll see between now and December 15 is the Bush tax cuts being extended for everybody for a period of time, but that a limit of deductions would kick in and also that they would do other cleanups like carried interest.”
That said, he cautioned that no one really knows the answer, and as we get closer and closer to December 15 (when Congress begins its winter break), we get closer to the fiscal cliff.
What Is Going To Happen To Dividend Tax Rates?
If we do go over the fiscal cliff, Gordon believes dividends will be the most affected because they get a tax break that dates back to 2003 and the Bush tax cuts.
Dividends are taxed at 15%, but if we go over the fiscal cliff and all the Bush tax cuts expire, dividends would go back to being taxed as ordinary income, which would be at a rate of 39.6%, plus the Medicare tax of 3.8%, and that comes into effect on 1 January 2013. That means we’re looking at a rate of 43.4% — nearly triple the current rate. (See “Dividends: Start Screaming.”)
If the Bush tax cuts are extended, Gordon notes that dividend taxes will still increase — the 15% statutory rate plus the 3.8% Medicare tax (i.e., 18.8%). This ”doesn’t sound like a large increase, but it is about a 25% increase in tax.”
But there is some good news. Gordon said he is “much more optimistic about dividends staying with a tax favored nature like long-term gains” than he is about the other Bush tax cuts. “I believe that eventually all the Bush tax cuts will expire, but they are going to separate out dividends and continue to give them a break.”
Why Would President Obama Give Dividends This Favored Treatment?
Gordon points out that the President’s first three budgets all had the Bush tax cuts expiring except for the dividend break. “In the last budget, the one he released this year, he repealed all the Bush tax cuts, including the dividend break,” Gordon said. “When pressed as to why that changed, the answer we have gotten is that he had realized he had given something up without getting anything back, and this was all going to turn into a horse-trading exercise, and he thought it best to take the dividend break off the table so that if he threw it back in he would be getting something back for it, meaning let the Republicans trade something for it.”
Gordon believes this is very telling. “I think it tells you where [Obama] would be willing to go, what he thinks is fair. Over the longer time period the Bush tax cuts will go, but the dividend break will stay.”
But, he warned, “If the fiscal cliff is triggered, then all bets are off.”
The Grand Compromise?
Gordon sees two aspects to what he calls a “grand compromise” (or what others refer to as a “grand bargain” between Democrats and Republicans to raise tax revenues and cut federal spending):
- First, a limit on the value of deductions (see “Protecting Your Deductions“). “As you see the talking heads on the TV over the next few weeks, you are going to hear about this more often,” Gordon said, adding that if Obama gets his way, he will limit the value of itemized deductions to no more than 28% (from 35% currently). “We may very well be in the bizarro world of thinking it’s good to both accelerate income and accelerate deductions” in 2012.
- Second, an extension of the Bush tax cuts for all for at least six months.
What To Do Now, Before Year-End?
Gordon had the following suggestions:
- Accelerate income that is known to be realized in 2013;
- Sell taxable bonds mid-coupon;
- Consider Roth conversions; and
- Sell taxable bonds with unrealized long-term gains.
For more on this topic, here are some recent articles that may be of interest:
- Obama Win: What It Means for Your Tax Bill (CBS MoneyWatch)
- Fresh from Reelection, President Finds Himself on Edge of “Fiscal Cliff” (Washington Post)
- Contemplating an 18% Long-Term Rate (InvestmentNews)
- Baird’s Steffen: Tax Hikes Coming Post-Election (OnWallStreet)
- The Tax Implications of Special Dividends (InvestmentNews)
- Key Tax Issues to Watch Post-Election (MarketWatch)
Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.