Should You Be Selling Now In Anticipation of Higher Tax Rates in 2013?

source:  Doug Short

One of the most common questions that has arisen in recent client meetings has been tax planning for 2013.

This is a very complex subject, so let me say at the onset that you should not make any final decisions based on my thoughts here today; please consult your tax advisor.

However, I wanted to pass along a couple of ideas

At this writing, with not only the Presidential race but numerous Senate campaigns very much up for grabs, it is difficult to know what tax rates will be in 2013.

The conventional wisdom is that if Governor Romney wins, tax rates on capital gains and dividends will remain relatively low:  15% on long-term capital capitals, and 15% on qualified dividends.

However, if President Obama is re-elected, it is possible that tax rates in 2013 could rise significantly, particularly if you include the 3.8% investment tax included as part of the Affordable Care Act (so-called Obamacare).

At the highest tax brackets, if tax rates revert to the pre-Bush era levels, long-term capital gains will be taxed at 23.8%, and taxes on dividends could rise as high as 43.8%.

Typically, if you ask most investment advisors, they will say something along the lines like "you should never let taxes dictate your investment decisions".  And while I agree in principal that this makes sense, I am not as certain that investors should at least be thinking about taxes as they consider not only low basis stock positions in their taxable portfolios, but their overall investment strategy as well.

Ned Davis Research (NDR) is out this morning with a piece that looks back at the last time there was a significant increase in capital gains taxes, in 1986. Analyst Lance Stonecypher of NDR writes the following:

The selling pressure on {stock} winners could be significant. {Looking at 1986} shows what happened to winners during the last half of 1986, the last time a capital gains tax of more than a full percentage point was being enacted....Stocks with high 52-week returns (i.e. momentum) significantly underperformed those with weak returns.  In fact, the top-decile momentum stocks produced a -0.6% return, while the bottom-decile stocks returned +20.7% between August 1986 and yearend (The tax hike was passed in October 1986, effective for the 1987 tax year.

In other words, taxes could play a major roles in stock market performance, especially as we approach year-end and we start to get some clarity in terms of which party will hold sway in Washington next year.

It is not clear what a rise in tax rates will do to dividend-paying stocks.  For example, telecommunication stocks have been big winners this year, largely due to their high dividend yields, and so could be vulnerable to profit-taking as we approach year-end, particularly if the elections skew more favorably to the Democrats.

However, NDR also points out that more than half of stock positions held by individuals are in tax-deferred accounts (e.g. IRA's and 401(k)'s), so any change in tax rates will not be a factor.  In addition, with bond yields so low, after-tax dividend yields for many stocks could remain above comparable corporate bond yields even if tax rates move to the highest rates.

Lots to think about.