To Play the Game To Win You Need to Know the Rules — Why the Economic Recovery Continues to Stumble

Last week I spoke in Las Vegas and thought of the myriad of games that people can play and hopefully win in the casinos.  Each game has a set of rules that the player needs to have full working knowledge of to optimize their potential outcome.  Without this full understanding of the rules, most people simply avoid those games.   If you play the game without full understanding of the rules, your probability of success in most circumstances is greatly diminished. 

Unfortunately, that is true today for investors.  We do not know the rules.  What will be the rules that investors will encounter on taxes?  What will be the capital gains tax rate next year?  What about the tax rate on dividends?  What expenses and contributions will be tax deductible and at what income level will some be phased out?  Will the Bush tax cuts be extended?   And what about the 3.8 percent surtax passed in 2010 to help finance the Affordable Care Act (ObamaCare) that will be applied on all investment gains greater than either $200,000 AGI for single individuals or $250,000 for married filing jointly.  While this tax will not be applied to income (wages, tips, social security…) all of these various  incomes will push dividend and capital gains into the 3.8 percent surtax range for many investors.  On what incomes and sale proceeds will this tax be imposed?   Even to this date, the IRS has yet to provide guidance and clarity to the 3.8 percent tax.  The answer is we do not know.  And hence we are not playing the game.  It is my opinion that this uncertainty is contributing to sputtering economic growth. 

Gross Domestic Product (GDP) is defined as:   GDP = Consumption + Investment + Government Spending + Exports – Imports

To date, GDP growth has significantly relied on government spending (which in a large part is borrowed money and is quickly expanding the federal debt burden).  See a previous blog. Investment has lagged because we did not know the rules.  GDP growth has been muted due to the lack of investment.

The Wall Street Journal had an excellent article pertaining to this, which is summarized below, along with my own personal input on a few issues.

Commencing January 1, 2013, an individual with $200,000 or more of adjusted gross income (AGI) , or a married couple filing jointly with an AGI of $250,000 and up, will see tax rates on dividends and capital gains (investment income) increase from 15 percent to 18.3 percent assuming that Congress extends the Bush tax cuts of 2001 and 2003 and that the President does not veto the extension. If Congress does not extend the Bush tax cuts and the law reverts to those previously in existence, then the top capital gains rate increases to 23.8 percent while the tax on dividends to individuals in the top income tax brackets jumps to 43.4 percent.

These tax rates would change the way Wall Street does business today and the way investors allocate their resources since dividends are already taxed at the corporate tax rate which tops out at 35 percent and then would be hit with a potential 43.4 percent income tax rate over and above that level.  For illustration, assume a corporation makes $100 pre-tax profit and is at the top tax bracket.  They would pay $35 of the $100 as tax, leaving after-tax income of $65.  If they paid all of this as a dividend, and assuming that the recipients were in the top tax bracket and that the top income tax rate was 43.4 percent, then the net after-tax proceeds of the original $100 pre-tax income would be $36.79 (assuming no state or local income taxes).  Hence, at the top brackets, potential tax on dividends could go as high as 63.21 percent (excluding any state or local income taxes).  The key here is we do not know what tax rates will be in effect and which investment(s) to make.  This delays our investment decisions and further stagnates economic recovery. 

Go to the IRS Form 1040 to see what is included in and the calculation of AGI. Essentially, AGI is calculated by adding income from wages, salaries, tips, taxable interest, ordinary dividends, tax refunds, alimony, business income, capital gains, IRA, pension and annuity distributions, rental income, unemployment compensation, social security benefits (the taxable component) and other income, less an array of expenses (including but not limited to health savings accounts, moving expenses, self-employment expenses, alimony paid….and so forth).  What do not reduce AGI are standard deductions or itemized deductions such as  charitable gifts,  mortgage interest, property taxes, state and local income taxes, and medical expenses (and other items included in IRS  Schedule A).

Specifically excluded from AGI, at least at this time, are some if not all gains on the sale of a primary dwelling as created by the Taxpayer Relief Act of 1997.   First, the residence had to have been occupied as the primary dwelling by the person/couple for two of the past five years (there are exceptions to this rule of which a few will be addressed).  A married couple can qualify for $500,000 of gains tax free on the sale of the dwelling while an individual can receive $250,000 tax free.  The total exclusion from taxes would be the purchase price of the property, plus capital improvements, and then either the $250,000 or $500,000 exclusion.  If the sales price of the dwelling is less than the total, then the property would not incur the 3.8 percent  surtax.  Any amount of gains in excess of the purchase price, capital improvements and the tax free component would incur the 3.8 percent investment surtax. 

There are some exceptions to the tax free component in sales of primary dwellings (always seek the counsel of a tax expert) for military personnel (they may not need to qualify for the two-year minimum stay), nor individuals that have had employment changes or health issues—in addition to others. 

While some might be skeptical about any homes having $250,000 to $500,000 gains in value, take a look at the median home price in California, which was $23,100 in 1970 — per U.S. Census Bureau — and in San Francisco had risen to $649,390 in March of 2012–per the California Association of Realtors®.

So what are the winning investments today?   Until the rules are known, this question cannot be answered.   But we can be assured that many investors will move to liquidate holdings in 2012 that would incur the 3.8 percent investment tax surcharge in 2013.  Also likely will be a shift to overweight in tax exempt bonds for the remainder of the year. 

Please Washington, D.C., define the rules so we can get on making the most optimal investment decisions possible.  Get with it or just get out of the way.


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