Tuesday, December 7, 2010

Q&A - What the Tentative Tax Deal Means for Investors

This week's question comes from Jim, an investor and reader who is wondering about the tentative deal to extend the Bush-era tax cuts.

Q: I saw on this morning’s news that there’s a deal on the table to extend the Bush-era tax cuts. How might this impact stock market investing?

Great question, Jim. First, and as you noted, this is not a done deal. Right now, there’s a potential tax cut extension deal in the works that would extend the Bush-era tax cuts for two years at all income levels. Also included in that package is a 13-month extension of unemployment benefits for the long-term unemployed and a 2% decrease in payroll taxes for all workers for one year.

I feel relatively certain that the extension will be enacted pretty much as it is currently written with some minor changes, and the basics of this deal are extraordinarily positive for stock market investing. The Bush-era tax incentives offer a 15% maximum tax rate for dividends and capital gains, and extending these incentives could not be any more bullish for the stock market. With this tax cut extension and with interest rates as low as they are right now, anyone who keeps money in a taxable money market account or CD instead of investing in the stock market is making an ill-advised choice.

For example, if an investor purchases a common stock today with a 5% dividend, even the after-tax (federal and state) return on that investment is 4%. Rarely in the history of investing have investors been able to earn 4% after taxes on any type of investment. Investors who invest in taxable money market accounts and in commercial bank CDs pay a maximum federal and state tax rate of approximately 40%. Therefore, for the pleasure of getting virtually no return on an inferior investment, the investor is punished by a much higher tax rate.

The basic intention of the tax cut extension is to drive money out of money market accounts and CDs and into stock market investing. This will fund economic growth and create stability in corporate America. Furthermore, over the last two weeks, there has been a lot of positive conversation about deficit reduction. The bipartisan deficit-reduction panel made what I consider to be fairly radical proposals to reduce the federal deficit over the next decade.

At the end of the day, the National Commission on Fiscal Responsibility and Reform did not receive the super majority of the committee voting on the proposals, but they did receive a simple majority. Some of the participants in this committee have already finished their political careers and made hard recommendations that would be very useful for the U.S. government to adopt. However, as is true to form at the federal level, the proposed tax deal announced last night by President Obama adds approximately $900 billion to the federal deficit over the next two years.

Nearly half of the money from this compromise package will be to finance social programs that will put money into the economy and hopefully help employment. One of the programs is the one-year 2% reduction in payroll taxes for all workers. Even though the employer will not be involved, this 2% will be immediately felt by all who are employed. As pointed out by the New York Times, a family earning $50,000 per year would receive a savings of approximately $1,000 while those who pay the maximum tax on income of $106,800 or more in 2011 would receive a savings of $2,136. This type of proposal has been recommended for years, but hopefully now be adopted. It will affect all working Americans and immediately put money into the economy.

As noted above, the package would include an additional 13-months of unemployment benefits for the long-term unemployed. Even though numerous studies indicate that long-term unemployment benefits probably does more harm than good for the economy, it is a humanitarian gesture. Studies indicate that when unemployment extends beyond a normal and reasonable time period, the unemployed tend to not take jobs that are available. Even though unemployment benefits are minimal, they tend to provide enough money where someone would not take a job they feel is inferior. With this extension, up to three years of unemployment benefits are paid in the United States. Unquestionably, unemployment benefits paid to those who are out of work are a necessary humanitarian effort and these benefits are quickly spent in the economy, creating additional stimulus.

The 2% decrease in payroll taxes along and the extension of unemployment benefits are very expensive programs, but they will hopefully add additional stimulus to the sluggish U.S. economy.

The most controversial provision announced by President Obama last night was the reintroduction of the estate tax in 2011. This will affect estates in excess of $5 million with an incremental rate of 35%. This is one provision that I anticipate will change before the deal is agreed upon, and everything I have read indicates that the preferred level will be $3.5 million at a 45% rate. The important point is that in 2010, there was no estate tax, but in 2011, there clearly will be.

Included in the bill are many other extensions of tax provisions that are related to businesses. However, the bill does fix the alternative minimum tax for 2011 so that the vast majority of Americans will not be impacted by this brutal add-on tax. There are many provisions under the proposed bill that would increase depreciation and extend additional pro-business and pro-investment credits.

Even though none of us want for this package to add to the federal deficit, none of us should be disappointed to see the lower tax rates extended for two more years. My post from last week indicated that we are now in the best investing environment in a decade. With the extension of the 15% capital gains and dividends tax rates for two more years, my theory raised in that post may be truer than ever.

Jim, I hope my explanation above has given you some insight as to how this tentative tax deal might affect the stock market and provide information on some of the other elements of the package on the table.

We encourage our clients and readers to send us questions for our Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Joseph R. Rollins