Dividend and Capital Gains Tax increase

[Hangingitup]

Hi all

Read that the new tax overhaul proposal taxes dividends at 43% and capital gains at 23.8% (from the current 15% for both). Since many retirees depend on these types of investment vehicles for income, seems to me this is potentially a huge consideration for ER. The rates quoted are for the "top" tax rates implying that rates are tiered. Nonetheless, still a significant hit.

Opinions on how realistic this is (will it happen?)?
Strategies on dealing with it if it does?

 

[MichaelB]

Hi all

Read that the new tax overhaul proposal taxes dividends at 43% and capital gains at 23.8% (from the current 15% for both). Since many retirees depend on these types of investment vehicles for income, seems to me this is potentially a huge consideration for ER. The rates quoted are for the "top" tax rates implying that rates are tiered. Nonetheless, still a significant hit.

People paying those rates will be declaring a whole lot of income, earned and investment. Good for them.

Opinions on how realistic this is (will it happen?)?

How can we tell? The scenario you describe is one possibility.

Strategies on dealing with it if it does?

Pay it. The IRS doesn't like tax evaders.

 

[LOL!]

First, I wouldn't worry about the "top" tax rates unless you have quite a lot of income. So you have to calculate the effect for yourself.

For me, the cap gains tax rate would be about 0%. The long-term cap gains tax rate would be 18% for me, but I won't even have to pay that. The reason is that I am not high income and will only have the holdings held for 5-years with gains. I have enough capital loss carryovers to last quite a while, so I will not be paying 18% for a number of years anyways. In the meantime, I will pay 0% on any realized cap gains.

 

[samclem]

Nobody knows what will happen, and (unfortunately) the decision will likely be rendered too late to allow much planing to be done.

If I had to guess: Neither LTCG or DIVs will be taxed higher than regular "earned" income at any income level.

The most obvious thing for folks to do right now is to take full advantage of the low 2012 CG and DIV/interest rates if they are eligible. That's the "bird in the hand" that we can count on. About 42 more days left to do that. . .

 

[rbmrtn]

I imagine most retirees will not be at an income level to be impacted by this. Strategy... I'll be buying good dividend payers that get thrown away in panic.

 

[Chuckanut]

One possibility would be to eliminate the capital gains tax and tax long term capital gains at regular rates, but allow people to adjust the capital gain for inflation. I don't necessarily advocate this, but I have heard it mentioned.

 

[samclem]

One possibility would be to eliminate the capital gains tax and tax long term capital gains at regular rates, but allow people to adjust the capital gain for inflation. I don't necessarily advocate this, but I have heard it mentioned.

I think that would make a lot of sense. Some people believe it would be an administrative nightmare, but I don't think so. We already have to track purchase dates and prices, applying the inflation rates to the intervening periods isn't hard with today's tools. Those doing taxes with pen and paper would object, I'm sure.

 

[ziggy29]

One possibility would be to eliminate the capital gains tax and tax long term capital gains at regular rates, but allow people to adjust the capital gain for inflation. I don't necessarily advocate this, but I have heard it mentioned.

Frankly I'm all for taxing all dividends and capital gains at ordinary rates IF AND ONLY IF:

1) Dividends are not doubly taxed; that is, businesses can pay them out pre-tax and then the recipient pays ordinary income tax rates (I believe REIT dividends already work this way);

2) Capital gains have their cost basis adjusted for inflation.

Do these two things and I'm all for treating all income the same in terms of tax rates.

 

[Animorph]

More dividend payers in the IRA's instead of taxable accounts would be a good move.

I think the possibility of a full hit in 2013 is very low.

 

[Nords]

Read that the new tax overhaul proposal taxes dividends at 43% and capital gains at 23.8% (from the current 15% for both). Since many retirees depend on these types of investment vehicles for income, seems to me this is potentially a huge consideration for ER. The rates quoted are for the "top" tax rates implying that rates are tiered. Nonetheless, still a significant hit.
Strategies on dealing with it if it does?

Hmmm, let's see what advanced techniques could help us cope with this disaster:
- Invest in low-cost index funds
- Max out tax-deferred (or tax-free) accounts
- Minimize trading & rebalancing
- Diversify.

Well, hey, whaddaya know, we don't have to change a thing!

 

[ziggy29]

Hmmm, let's see what advanced techniques could help us cope with this disaster:
- Invest in low-cost index funds
- Max out tax-deferred (or tax-free) accounts
- Minimize trading & rebalancing
- Diversify.

Well, hey, whaddaya know, we don't have to change a thing!

The biggest difference I see is that with the current tax structure, it was often best to buy and hold dividend stocks in taxable accounts to lock in the 10-15% rate instead of paying ordinary income rates from an IRA or 401K contribution.

But if dividends are taxed as ordinary income, dividend stocks would be more like bonds in a portfolio: best held in tax-deferred accounts, not taxable accounts.

 

[foxfirev5]

Basically for better or worse, virtually all my equity is in tax deferred or Roth accts. By investing new 401k and Roth $ in cheaper equities and rebalancing I plan to increase my # of shares if prices continue to drop. Of course this is what I would have done anyway.

 

[Gumby]

. . .
2) Capital gains have their cost basis adjusted for inflation.

Do these two things and I'm all for treating all income the same in terms of tax rates.

On the face of it, this seems like a good idea. If I own one share of stock today that trades at $10.00 a share, I could sell it and buy 4 loaves of bread. If, due to inflation, in five years my share of stock is worth $20.00, but I can still only buy four loaves of bread with it, why should I be taxed on the $10 increase?

But then lets look at labor. Today, I have one hour of my time that I can sell for $10.00, with which I can buy 4 loaves of bread. If, again due to inflation, I am selling my hour for $20.00 in five years, but still can only buy four loaves of bread, why shouldn't I get the same inflation indexing for my tax bill?

A conundrum for which I do not have a good answer.

 

[samclem]

On the face of it, this seems like a good idea. If I own one share of stock today that trades at $10.00 a share, I could sell it and buy 4 loaves of bread. If, due to inflation, in five years my share of stock is worth $20.00, but I can still only buy four loaves of bread with it, why should I be taxed on the $10 increase?

But then lets look at labor. Today, I have one hour of my time that I can sell for $10.00, with which I can buy 4 loaves of bread. If, again due to inflation, I am selling my hour for $20.00 in five years, but still can only buy four loaves of bread, why shouldn't I get the same inflation indexing for my tax bill?

A conundrum for which I do not have a good answer.

I'm not quite following you. The cases are being treated the same. In the case of labor, each hour you start with zero income and taxes, but at the end of the hour you have produced something worth either $10 or $20 to someone and you sold your labor and were taxed on the entire amount (because the entire amount was a gain to you). In the case of the stock you are being treated just the same--you are being taxed on the amount that was a (true) gain to you (zero, because you paid the same real amount for the stock as you received).
Maybe.

 

[GrayHare]

One possibility would be to eliminate the capital gains tax and tax long term capital gains at regular rates, but allow people to adjust the capital gain for inflation. I don't necessarily advocate this, but I have heard it mentioned.

Doubt that will happen since IMO the "inflation tax" is the plan for paying down the national debt.

 

[Gumby]

I'm not quite following you. The cases are being treated the same. In the case of labor, each hour you start with zero income and taxes, but at the end of the hour you have produced something worth either $10 or $20 to someone and you sold your labor and were taxed on the entire amount (because the entire amount was a gain to you). In the case of the stock you are being treated just the same--you are being taxed on the amount that was a (true) gain to you (zero, because you paid the same real amount for the stock as you received).
Maybe.

Try this

Today, you have one share of Corning (GLW) that you can sell for about $10. In five years, you can sell it for $20.00. Assume that inflation is the only reason the stock went up. You say -- "its unfair to tax me on those extra $10. That was inflation. I am no better off than before. I still only have one share of GLW to sell."

Today, I have one hour of my time that I can sell for $10. Assume that solely due to inflation, my hourly rate goes up to $20 in five years. At that time, I can sell one hour of my time for $20. I say -- "it's unfair to tax me on the extra $10. That was inflation. I am no better off than before. I still have only one hour of my time to sell."


The only difference that I can see is that the hours of my day are constantly expiring at day's end and being renewed the next morning, whereas the share of stock is (generally) a thing that exists unchanged forever. Yet, I don't see how this difference necessarily changes the outcome.

 

[MichaelB]

On the face of it, this seems like a good idea. If I own one share of stock today that trades at $10.00 a share, I could sell it and buy 4 loaves of bread. If, due to inflation, in five years my share of stock is worth $20.00, but I can still only buy four loaves of bread with it, why should I be taxed on the $10 increase?

But then lets look at labor. Today, I have one hour of my time that I can sell for $10.00, with which I can buy 4 loaves of bread. If, again due to inflation, I am selling my hour for $20.00 in five years, but still can only buy four loaves of bread, why shouldn't I get the same inflation indexing for my tax bill?

A conundrum for which I do not have a good answer.

I'm no tax expert but was under the impression that your tax liability reflected two inflation adjustments: one for exemptions and the other for tax brackets, meaning your labor is indexed to inflation.

 

[ziggy29]

On the face of it, this seems like a good idea. If I own one share of stock today that trades at $10.00 a share, I could sell it and buy 4 loaves of bread. If, due to inflation, in five years my share of stock is worth $20.00, but I can still only buy four loaves of bread with it, why should I be taxed on the $10 increase?

But then lets look at labor. Today, I have one hour of my time that I can sell for $10.00, with which I can buy 4 loaves of bread. If, again due to inflation, I am selling my hour for $20.00 in five years, but still can only buy four loaves of bread, why shouldn't I get the same inflation indexing for my tax bill?

Because tax brackets are already adjusted for inflation every year. If inflation doubles in those 5 years, the tax brackets will adjust to it and the overall "effective tax rate" will be the same on $80K in five years as it is for $40K today.

In other words, someone earning $40K per year today and $80K in five years in your scenario will be in the exact same place in terms of tax brackets. Before tax reform addressed "bracket creep" in the 1980s, your example was a very real and serious one.

Cost bases for determining capital gains, unlike tax brackets, are not adjusted for inflation. I understand your concern -- passive income should not taxed less over earned income -- but I don't see that happening in my suggestions. In fact, what I suggested would eliminate the only defensible reasons (IMO) why dividends and LTCG get lower tax rates than earned income.

 

[samclem]

Try this

Today, you have one share of Corning (GLW) that you can sell for about $10. In five years, you can sell it for $20.00. Assume that inflation is the only reason the stock went up. You say -- "its unfair to tax me on those extra $10. That was inflation. I am no better off than before. I still only have one share of GLW to sell."

Today, I have one hour of my time that I can sell for $10. Assume that solely due to inflation, my hourly rate goes up to $20 in five years. At that time, I can sell one hour of my time for $20. I say -- "it's unfair to tax me on the extra $10. That was inflation. I am no better off than before. I still have only one hour of my time to sell."


The only difference that I can see is that the hours of my day are constantly expiring at day's end and being renewed the next morning, whereas the share of stock is (generally) a thing that exists unchanged forever. Yet, I don't see how this difference necessarily changes the outcome.

Let's say that your tax rate is 15%. In the case of the labor, if today you earned $10 in that hour you pay $1.50. Five years later, you pay $3, but it's worth exactly the same--you've experienced zero increase in taxes because of inflation. (of course, our tax rates are also indexed for inflation, so you woudn't pay a higher rate).
In the case of the stock, you haven't said what you paid for it, so we don't know your gain. Let's say you bought it yesterday for 1 cent and today it is worth $10.01. Now we have a situation that is analogous to your case with the labor: If you realized the gain (by selling it) you'd owe 15% tax on your $10 gain (just like with your labor if you earned $10 in that hour, a $10 gain) and in five years (when the stock is worth $20.01 in inflated dollars) you'd owe $3 in taxes. Just like with the labor.

In a nutshell, I think the problem with your scenarios are that they ignore the "basis" of the labor: It is zero, so every penny you earn is a gain. With the stock, you are also taxed just on the gain.

 

[ziggy29]

In a nutshell, I think the problem with your scenarios are that they ignore the "basis" of the labor: It is zero, so every penny you earn is a gain. With the stock, you are also taxed just on the gain.

I'd put it this way: Is a dollar earned in January worth as much in an inflationary enviroment as a dollar earned in December? No.

But unless inflation is ferociously ridiculous, it doesn't create the huge inequity that the current capital gains system does. Typically that's noise, and next year's brackets will reflect the eroding value of a dollar.

Let's say we hit a bad stretch where inflation rages at 10% for 7 years. (Per the rule of 72, that means roughly doubled prices in 7 years.)

If you buy stock for $350K and sell it for $700K in 7 years, you have NO real gain, but you pay taxes on half the sale. (Even with 15% rates you are paying taxes on NO real gain!)

When you earn income, the brackets adjust each year. If you get a 10% "raise" to match inflation (like raises happen any more), your effective tax rate does not change AT ALL. Inflation adjustments are baked into the brackets. Inflation considerations for the cost basis on capital gains and losses are not.

 

[Gumby]

Because tax brackets are already adjusted for inflation every year. If inflation doubles in those 5 years, the tax brackets will adjust to it.

In other words, someone earning $40K per year today and $80K in five years in your scenario will be in the exact same place in terms of tax brackets. Before tax reform addressed "bracket creep" in the 1980s, your example was a very real and serious one.

Cost bases, unlike tax brackets, are not adjusted for inflation. I understand your concern -- passive income should not be favored over earned income -- but I don't see that happening in my suggestions.

I'm still not convinced.

Let's say I am currently in the 25% marginal bracket. If I work for one hour for $10 (i.e - sell my "asset" of one hour labor), I'll pay $2.50 in taxes. Because the brackets are indexed for inflation, in five years, even if my pay rate doubles, I'll still be in the 25% bracket. Now, however, I'll pay $5.00 in tax (25% x $20.00)

Now let's assume a world where capital gains are taxed as ordinary income. Let's also assume that my doppelganger has income from selling shares of stock such that he is also in the 25% bracket. Instead of an hour of labor, he has a share of GLW as his asset. He can sell it (his asset) for $10.00 and pay $2.50 in taxes. In five years, if prices have doubled solely due to inflation, he sells his share for $20.00 and pays $5 in tax, because he is still in the 25% bracket due to inflation adjusted brackets.

Finally, let's assume a world with inflation indexed capital gains. In five years, when I sell my asset (my hour of labor), I pay $5 in tax. But when my doppelganger sells his asset (his share of GLW) in five years, he pays only $2.50 in tax. And yet those two things (an hour of time and a share of GLW) are equal in real value today and equal in real value in five years.

 

[ziggy29]

Let's say I am currently in the 25% marginal bracket...

Now let's assume a world where capital gains are taxed as ordinary income. Let's also assume that my doppelganger has income from selling shares of stock such that he is also in the 25% bracket. Instead of an hour of labor, he has a share of GLW as his asset. He can sell it (his asset) for $10.00 and pay $2.50 in taxes. In five years, if prices have doubled solely due to inflation, he sells his share for $20.00 and pays $5 in tax, because he is still in the 25% bracket due to inflation adjusted brackets.

Finally, let's assume a world with inflation indexed capital gains. In five years, when I sell my asset (my hour of labor), I pay $5 in tax. But when my doppelganger sells his asset (his share of GLW) in five years, he pays only $2.50 in tax. And yet those two things (an hour of time and a share of GLW) are equal in real value today and equal in real value in five years.

The $10 the stock owner paid T-5 years ago was taxed T-5 years ago. If prices double over 5 years, a worker that earns twice as much as he/she did in year T-5 has not had their effective tax rate changed because brackets are indexed.

The owner of stock, however, has no such indexing. The tax code protects earned income from inflation by adjusting the brackets annually. The tax code has NO accounting for "phantom" capital gains due only to inflation.

If I buy a share of stock with $10 (one hour of my time in your example), and inflation now makes one hour of time worth $20 in five years... if I sell it for $20, what have I gained? To suggest I should pay ordinary income tax on half of the purchase price, when I have gained ZERO in real terms, seems really unfair. And it would devastate the incentives to long-term investing.

 

[Gumby]

In the case of the stock, you haven't said what you paid for it, so we don't know your gain. Let's say you bought it yesterday for 1 cent and today it is worth $10.01. Now we have a situation that is analogous to your case with the labor: If you realized the gain (by selling it) you'd owe 15% tax on your $10 gain (just like with your labor if you earned $10 in that hour, a $10 gain) and in five years (when the stock is worth $20.01 in inflated dollars) you'd owe $3 in taxes. Just like with the labor.

The basis issue may indeed be the answer to my dilemma. In my hypothetical, I assumed that all of the $10 value of the stock was taxable if sold today. That almost certainly is not true. You likely already paid taxes on the labor you expended to get the money to buy the stock in the first place. Whereas the laborer has not paid any taxes yet on the hour of time he has in his pocket.

Let's assume you worked yesterday for an hour and ten minutes, paid ten minutes worth of tax ($1.50) and used the remaining $10 to buy stock, which today is still selling for $10.00. If you sold, you would have no cap gains and hence no tax. So now, you and the laborer have an asset of equal value, but you have already paid $1.50 in tax. In five years, if prices double for both you and laborer, but your cap gains are inflation indexed, you will not pay any more tax. The laborer will pay $3 in tax on the hour he sells then. But the tax paid will have the same real value as the $1.50 you paid yesterday.

I'm glad we had this discussion. It has helped to clarify my thinking on this issue.

 

[Amethyst]

Pension income is taxed at ordinary income rates. Dividend income is modest at best. So, very little impact to us, except when selling real estate (paper gains, more than offset by carrying costs).

One thing I can't understand: Since real estate capital gains are taxed, why can't real estate capital losses be used to offset capital gains?

Amethyst

 

[Gumby]

The $10 the stock owner paid T-5 years ago was taxed T-5 years ago.

That's exactly what I was not seeing properly. Thanks for helping me think through this.