Should investors worry?

ARTICLE  | 

Authored by RSM US LLP

Source: Tax Policy Center , Yahoo Finance

The White House just announced another broad stimulus package that the president would like to fund, in part, with an increase in long-term capital gains tax rates. As part of the plan, those earning in excess of $1 million may face a near-doubling of the current rate (to 39.6%) — a level not seen since the 1920’s. With the slimmest of majorities in Congress, Democrats will be hard-pressed get the bill through Congress as proposed. Nevertheless, investors are understandably concerned about what a higher capital gains rate would mean for their wealth accumulation. While every portfolio is different, looking at the behavior of the broader market can provide insight.

Since 1954, there have been 14 changes in the long-term capital gains tax rate — eight increases and six decreases. On average, the S&P 500 Index was up 9.4% over the subsequent 12 months. Perhaps surprisingly, the direction of the change did not matter much for performance; the average return when the rate decreased was 9.5%, while the average return was 9.4% when it increased. Focusing on the six months prior to an increase in the long-term rate, a period when investors would likely be making portfolio adjustments in anticipation of a rate change, the Index was still up average of 5.1%.

What this suggests to us is that the market at large still focuses on corporate earnings and the economic environment when determining the fair value of equity prices. For example, equities retuned 29.6% in the 12 months following the 2013 tax rate increases as the economy gained steam and deft Fed tapering kept rates acceptably low. On the other hand, stocks fell despite a 1981 cap gains rate cut due to Middle East unrest and restrictive Fed actions.

Consequently, while individual investors may benefit from portfolio adjustments prior to known changes in the long-term capital gains rate, preemptive buying and selling conducted by individual investors does not appear to have a material impact on performance. Therefore, investors should consult with their advisor about whether to make portfolio changes in anticipation of an increase in the long-term capital gains tax rate, but the consequences to the equity market in aggregate should not keep them up at night.

1Maximum rates include the effects of exclusions (1954-86), alternative tax rates (1954-86,1991-97), minimum tax (1970-78), alternative minimum tax (1979-), income tax surcharges (1968-70), phase-outs of itemized deductions (3% 1991-2005 and 2013, 2% 2006-07, 1% 2008-09) and the 3.8% tax on net investment income (2013). The maximum statutory rate on long-term gains was 28% starting 1991, 20% starting May 1997, 15% starting May 2003 and 20% starting in 2013. The 2008-9 maximum rate includes the effect of the 1% itemized deduction phase-out, computed as 15.35=15+.01*35. Starting 1997, gains on collectibles and certain depreciation recapture are taxed at ordinary rates, up to maximum rates of 28% on collectibles and 25% on recapture. Tax rates changed midyear in 1978, 1981, 1997 and 2003.

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This article was written by RSM US LLP and originally appeared on 2021-04-30.
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