How Tax Cut On Investments May Affect You
With Tuesday’s budget agreement investors will get their biggest tax cut since the early 1980s, as the federal government slashes the share it demands of long-term capital gains.
That provision has broad implications for all investors and, of course, for financial markets. Here are answers to some key questions:
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Q: How big a tax cut does the budget deal authorize?
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A: The top federal tax rate on long-term capital gains--that is, the tax on any long-term price appreciation of securities, real estate, a business, etc.--would be cut to 20% from 28%. That would return the rate to the level it was from 1982-87, before Congress raised it in steps. The top rate has been 28% since 1990.
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Q: How does the bill define a “long-term” holding?
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A: That is perhaps the biggest surprise in the legislation. For an asset sold from now on (actually, as of Tuesday), you must have owned the asset for at least 18 months to qualify for capital gains treatment. Historically, that holding period has been 12 months. A gain on any asset sold within 18 months of purchase would be taxed at ordinary income rates--up to 39.6%.
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Q: I thought Congress was planning to make the lower capital gains tax rate apply to any asset sold after May 6 of this year. Wasn’t that what congressional leaders said in May and June?
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A: Yes--and in fact, they’re keeping their word: The bill allows any capital gain realized between May 6 and Monday to be taxed at the lower 20% rate. And for those sales, the holding period to qualify for capital gains treatment remains 12 months.
In effect, the bill penalizes investors who have waited since May 6 to sell an asset: They, too, would get the lower 20% top tax rate, but if they haven’t yet owned the asset for 18 months, they’ll have to wait until that period is up to avoid being taxed at ordinary tax rates.
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Q: Would the 20% capital gains rate apply to everyone and every long-term asset?
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A: No. Lower-income earners--specifically, married couples filing jointly and earning less than $41,200 next year--would face a top capital gains rate of just 10%.
And beginning in 2001, the top rate for assets purchased thereafter and held more than five years would drop to 18% from 20%. But that would mean an investor couldn’t realize that benefit until 2006 at the earliest.
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Q: Wasn’t there talk about indexing capital gains for inflation?
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A: Yes, but Republicans and the White House couldn’t agree on that provision, so there is no allowance for indexing. Of course, in the current low-inflation environment, that is less important.
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Q: Would a lower capital gains tax rate be a plus or a minus for share prices in the near-term?
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A: Some analysts worry that the tax break could encourage pent-up selling of stocks by investors who are uncomfortable with the market’s heights. But because so much stock wealth is tied up in pension funds and in long-term, tax-deferred accounts today--such as corporate 401(k) savings plans--it isn’t clear how much of an effect the investors who hold shares outside those places can really have on the market.
What’s more, many accountants say that clients who were nervous about the stock market sold in May, June or earlier this month, when they had a reasonable expectation that a capital gains tax cut would be retroactive.
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Q: So this should be bullish for the stock market?
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A: In the long run, it’s hard to imagine why it wouldn’t be. Consider: In a market where investors already care relatively little for bonds and other investments that generate fully taxable income (such as interest payments), there now will be even more incentive to avoid those assets in favor of those--especially stocks--that generate long-term capital gains.
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Q: Would this tax cut also reduce the relative appeal of stocks that pay big dividends?
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A: In theory, yes. Dividends, like interest, are taxed at ordinary rates. So more companies may use the capital-gains tax cut as justification for minimizing cash dividend payments, and using capital instead to buy back stock or make other moves designed to push their share prices higher--producing heftier capital gains for investors.
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Q: Will I need to consider major changes to my investment portfolio if this tax cut passes?
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A: Probably not. Many investors already consider themselves long-term, buy-and-hold stock investors, and this legislation just rewards that strategy further.
Even though the capital gains tax would come down under the bill, most investors should probably continue to invest as much as they can in tax-deferred accounts such as 401(k) plans, experts say. Especially if your employer is matching your contribution, those accounts are the best deal going.
But because money that you will eventually pull from such retirements accounts will be taxed at ordinary income tax rates when withdrawn, some experts say a lower capital gains tax rate could make it more appealing for some investors to begin accumulating more capital-gains-generating assets outside tax-deferred accounts, to take advantage of the lower capital gains tax rate. That may be particularly true for investors who are nearing retirement.
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Good for Gains
The new tax bill would cut the top federal tax rate on long-term capital gains to 20% from 28%, while the top tax rate on ordinary income--such as wages, interest and dividends--would remain at 39.6%.
Top tax rate, ordinary income: 39.6%
Current top capital gains tax: 28.0%
New top capital gains tax: 20.0%
New top capital gains tax, lower-income investors*: 10.0%
* For joint filers earning less than $41,200 in 1998
Source: Senate Budget Committee
