Nothing is so certain in life as death and taxes. Or so we're told. Actually, though, there may be a third "certainty" as well.
"Change," says Suzanne Shier, senior vice president and director of wealth planning and tax strategy at Northern Trust. "Especially when we're talking about taxes."
Point well taken. By one estimate, there were 5,000 changes to the tax code over the last 10 years.1 And that was before the frenzied year-end fiscal cliff negotiations.
So when it comes to taxes, don't get too comfortable with the status quo.
Which may be just fine with investors, many of whom aren't at all comfortable with the higher tax bills they'll face in 2013 and beyond. And it's not just investors who'll be impacted. According to the nonpartisan Tax Policy Center, about three-quarters of all Americans will pay more in taxes this year.2
Yet financial markets rallied despite the political turmoil. And with good reason.
"It's not as if we didn't see the budget battle coming," says Jackie Benson, senior equity research analyst and portfolio manager of the Northern Income Equity Fund. She was referring to the debt ceiling brouhaha that set the fiscal cliff clock ticking. "The details were uncertain, but higher taxes already were baked in the cake."
Only this was no chocolate cake with lots of tasty frosting. Indeed, businesses and investors recoiled at the menu of potential tax increases. Some didn't even wait for cliff negotiations to conclude before acting on a broad range of possible outcomes.
Assuming dividend taxes were going to rise, some companies paid special dividends to soften the tax hit on shareholders. Investors sold winners early and held on to losers, the opposite of the familiar year-end tax strategies. Municipal bond prices slumped in December, marring an otherwise solid year.
Despite the long period of uncertainty over rates, deductions and exemptions beginning in 2013, two categories of tax never were in serious question.
As part of bipartisan stimulus legislation passed in the wake of the Great Recession, the employee share of Social Security taxes was temporarily cut from 6.2% to 4.2%.3 The "tax holiday" was extended twice, but it expired at the end of 2012 and is not coming back.
The lower tax rate saved a family of four earning $50,000 a year about $41 per biweekly paycheck.4 Overall, taking the employee's share of the so-called payroll tax back to the previous 6.2% rate will remove an estimated $126 billion from the U.S. economy in 2013.5
The second new tax — actually three Medicare-related taxes — applies to high-income taxpayers.
As of January, a 0.9% tax on an employee's wages in excess of $250,000 for a married couple filing jointly, $125,000 for a married person filing separately, and $200,000 for others kicked in, as well as a 0.9% tax on self-employment income in excess of these thresholds.6
Then there's the 3.8% Medicare contribution tax, specifically targeted at the net investment income generated by high-income households.
Interest, dividends, and capital gains are potentially subject to the tax, though retirement income, such as that from a traditional IRA, is exempt.7
But these taxes aren't all that's going up.
The tax agreement reached between Christmas and New Year's — only the fourth time in history that Congress met during that typically relaxed time of year — raised the top marginal tax rate on household taxable income over $450,000 ($400,000 for singles) from 35% to 39.6%.8 Itemized deductions and personal exemptions now are subject to phaseout at adjusted gross income of $250,000 for singles and $300,000 for married couples filing jointly.9
For investors, the impact of those changes will be three-fold.
Consumer spending accounts for about two-thirds of gross domestic product. And with less money available for consumption, economic growth will face a headwind. Slower growth, in turn, could restrain corporate profits. Skinnier paychecks also means less money is available for investing.
But none of this necessarily assures trouble ahead for stocks or bonds.
The fiscal drag from the new taxes could be offset by continued recovery in the housing market and by a pickup in business spending. Companies have been reluctant to take on workers and invest in plants and equipment because of uncertainty regarding the shifting tax landscape. Consumer confidence also has fallen recently.
"Once fiscal policy is settled and everyone knows the rules, we could have a good tailwind behind stock prices," says Benson.
Still, there is more uncertainty ahead, including a potentially bitter budget battle in late winter or early spring over spending cuts and the debt ceiling. Investors also face changes on two sources of return: qualified dividends and long-term capital gains.
Flush with cash
Dividends usually have been treated as ordinary income and docked at the income tax rate, minus a small exclusion. Since 2003, however, qualified dividend income had been taxed at the long-term capital gains rate of 15% for middle- and upper-income taxpayers.10
Under the fiscal cliff agreement, the top qualified dividend rate increases to 20% for individuals and households in the 39.6% marginal tax bracket, but remains at 15% for those in the 35%, 33%, 28% and 25% brackets.11
Those terms are relatively favorable by historical standards.
Which is important, because since 1930, dividends have accounted for 42% of the total return of the S&P 500.12
Various factors also could mitigate the impact of the modest rise in dividend taxes.
American corporations hold a record $1.5 trillion in cash. Plus, the payout ratio of large U.S. corporations is near an all-time low.13
"Companies have the means to increase dividends and the incentive to do so," notes Benson. That's because restricted stock units are an increasingly popular form of compensation for upper management, replacing stock options.
"The cash is there, the payouts are low, and the executive management teams have more exposure to dividends from a compensation standpoint," Benson says.
So what's the bottom line for dividend-hungry investors concerned about a change in how cash payouts are taxed?
"Dividends always have been important to total return, and I doubt that's going to change," says Benson. Her advice to income-hungry investors: Stay the course.
Still a good deal
A similar approach seems appropriate to capital gains taxes. As with dividends, those tax rates will remain below the long-run average.
Since 1954, the maximum tax rate on long-term capital gains averaged about 25%.14 As of January, however, the longterm gains rate rises from the recent low of 15% to 20% under the same formula used to compute dividend taxes.15
So despite the increase, capital gains still will receive favorable treatment relative to many other periods, some of which were exceptionally profitable for investors.
During the Great Bull Market of 1982 to 2000, the maximum long-term capital gains rate averaged approximately 25%, five percentage points higher than the new rate.16
Besides, Shier notes that sidestepping capital gains taxes is not an end in itself. Indeed, one way to cut your tax bill is to generate capital losses.
"And who wants those?" she asks.
Finally, the tax-free bond market navigated the gauntlet of threatened tax hikes and emerged unscathed so far.
As the cliff approached, though, municipal bond yields rose to levels that appeared to discount the possibility that the sector might lose some of its tax-exempt status.
"The market overshot, but that's what happens when people are worried," said Tim McGregor, director of municipal fixed income portfolio management at Northern Trust.
With the status quo preserved, McGregor thinks the December sell-off might have created a buying opportunity, especially with the top income tax rate set to rise. Besides, municipalities have curtailed issuance, making existing bonds more valuable.
"Municipal yields have fallen sharply in recent years," McGregor says. "But the asset class still looks attractive on an after-tax basis, even for middle-income taxpayers."
For all the uncertainty and complexity, it's helpful to keep the tax issue in perspective.
"Taxes are a factor in how you should invest, but they aren't the only factor or even the dominant one," Shier says. "If there is a tax component, that should be part of the risk-reward calculation that goes into making a sound investment. But, there is a difference between being mindful of taxes and being driven by them."
And that's probably just as well, since if you wait long enough — actually, probably not that long at all — the tax code will change yet again.
Of that we can be certain.
Bond Risk: Bond funds will tend to experience smaller fluctuations in value than stock funds. However, investors in any bond fund should anticipate fluctuations in price, especially for longer-term issues and in environments of rising interest rates.
Tax-Free/AMT Risk: Tax-exempt funds' income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax.
IRS CIRCULAR 230 NOTICE: This information is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see northerntrust.com/circular230.
1 "Dave Camp: Is Tax Reform Politically Possible?" Stephen Moore. The Wall Street Journal. August 10, 2012.
2 "Bipartisan House Backs Tax Deal Vote as Next Fight Looms." Richard Rubin, Roxana Tiron, James Rowley. Bloomberg. January 2, 2013.
3 "There's Part Of The Fiscal Cliff That Hits Workers Directly — And Almost Nobody Is Talking About Fixing It" Joe Weisenthal. Business Insider. November 25, 2012.
4 "Fiscal Endgame." The New York Times. December 26, 2012.
5 "There's Part Of The Fiscal Cliff That Hits Workers Directly — And Almost Nobody Is Talking About Fixing It" Joe Weisenthal. Business Insider. November 25, 2012.
6 "Tax Transitions 2012–2013." Suzanne L. Shier. Northern Trust. November 13, 2012.
8 "Bipartisan House Backs Tax Deal Vote as Next Fight Looms." Richard Rubin, Roxana Tiron, James Rowley. Bloomberg. January 2, 2013.
10 "Tax Transitions 2012–2013." Suzanne L. Shier. Northern Trust. November 13, 2012.
11 "High Earners Facing First Major Tax Increase in Years." Laura Saunders. The Wall Street Journal. January 1, 2013.
12 "US Equity Strategy: The 2013 Playbook." Morgan Stanley. November 26, 2012. Exhibit 29, page 12.
13 "US Equity Strategy: The 2013 Playbook." Morgan Stanley. November 26, 2012. Exhibit 30, page 13.
14 Department of the Treasury, Office of Tax Analysis.
15 "High Earners Facing First Major Tax Increase in Years." Laura Saunders. The Wall Street Journal. January 1, 2013.
16 Department of the Treasury, Office of Tax Analysis.