Capital Gains Up! Stocks Down?
Now we know who the next President will be. With Barack Obama becoming our Commander-In-Chief, he also takes the role of spearheading a new direction for our country. The question is: does that mean you should sell off a lot of your stocks?
No, I’m not worried about President-elect Obama destroying the U.S. economy. But he has said that he wants to raise the capital gains tax rate. This could cause a lot of people to think about selling many of their investments.
No one knows what is going to happen to taxes. Campaign promises are noticeably vague and, after all, the President doesn’t pass tax legislation, Congress does. Nevertheless, people will take actions based on what they think President Obama and Congress might do next year.
Let’s imagine that you are one of those evil rich people that everyone wants to tax more. That puts you in the 35% tax bracket. Let’s also pretend that you are sitting on a stock that is worth $100,000. You were an astute investor and purchased the stock long ago when it was worth $10,000. The difference between the two, $90,000, is your capital gain. And by golly, you owe a lot of that to the American people.
If you were to sell the stock under the present tax laws, you would be taxed at the 15% tax rate, owing $13,500 in taxes. But what if the capital gains tax rate were made equal to a person’s marginal tax bracket next year? If that happened and you sold the stock, you would owe $31,500 in taxes. That’s a 133% increase in the taxes you’ll have to pay. And what if on top of that they raised your tax bracket to 40 or 50%?
I don’t know about you, but if I were rich, that prospect would get my attention.
You may say to yourself, “That’s not my problem” as you are not rich. Don’t be so fast with your smugness. If you happen to own that same stock and all the rich folks start to sell it, what do you think will happen to the price? The scenario being built by a wide range of folks is that capital gains related selling will cause the stock market to plummet.
Now that I’ve got you sufficiently scared and about to call your broker, let me calm the waters a bit. If you examine what happened in the past when the capital gains tax rate was increased, you’ll see that less than 20% of the time did the market drop. Don’t get me wrong, the market wasn’t good; it averaged about 4.8%...not down, but not exactly stellar.
Why doesn’t the stock market normally plummet? There are several reasons. First, you don’t sell, you don’t have to pay any taxes, large or small. Keeping their money compounding tax-deferred can often override any tax hike on the wealthy if left alone to grow long enough.
Next, just like you, the well-to-do have a lot of their investments in tax-deferred accounts like IRAs and 401(k)s that don’t generate any taxes on gains that stay inside the account. And when they take the money out of the account in their retirement, they weren’t going to get capital gains treatment anyway.
And last, consider what all those rich people do once they sell their stocks and pocket the gain? They buy more stocks. So they’ll either buy back the same stock or they’ll buy a different stock. Either way, most of the money only sits on the sidelines for a few days or months.
Gary Silverman, CFP® is the owner of Personal Money Planning, a financial planning and investment management firm located in Wichita Falls. You may e-mail him at Gary@PersonalMoneyPlanning.com