Tax efficiency is a key goal of any investment strategy. Over time, investors have become better at avoiding taxes by investing in tax efficient ETFs, and tax shelters like real estate, master limited partnerships, and municipal bonds. This is a great strategy if looking to avoid the capital gains tax 2013 increases.
Avoiding capital gains taxes is so critical to investment performance that it absolutely cannot be ignored. Most active fund managers underperform the market in part because they generate more and higher tax liabilities for investors. Individual investors are likely to lag their retirement needs because they fail to account for capital gains taxes when making an investment.
As a reminder, here are the capital gains tax 2013 increases:
- Long term capital gains will be taxed at:
- 20% for individuals making over $400,000
- 15% for individuals in the 25% to 35% tax bracket
- 0% for individuals in the 15% or lower tax bracket
- Net investment income (Capital gains and dividends combined) over $200,000 will be subject to an additional 3.8% Medicare tax
- Modified Adjusted Gross Incomes (MAGI) over $200,000 will be subject to additional 3.8% Medicare tax on all dividends and capital gains, regardless of the amount
- Qualified dividends will now be taxed at 20%, instead of 15%, for individuals earning more than $400,000, while ordinary dividends will be taxed at your current income tax rate
Four Ways to Look at Capital Gains Tax 2013
The capital gains tax isn't just a tax assessed on earnings. It's a tax that substantially changes the way investors should and do allocate capital to the best investments.
The capital gains tax is really four different kinds of investment taxes rolled up into one:
- Inflation Tax – Investors have to account for the fact that the capital gains tax is, in a way, a simple tax on inflation. While investments of all kinds have beaten the rate of inflation in the long-haul, the rate of inflation is anything but constant. If one earns 8% per year in an environment with 3% inflation, investors incur a tax burden on the total return, not just the return excluding taxes.
- Transaction Tax – The capital gains tax is really a tax on transactions, not a tax on gains. Gains by themselves are not taxed at the capital gains tax rate. Rather, collected gains from the sale of a security or investment are taxed. The difference is important. Swapping one winning stock for a new pick which you believe will perform even better is costly. Each swap will cost you as much as 23.8% in capital gains taxes. Don't move your money unless your new hot pick is at least 23.8% better than your current pick.
- Wealth Tax – The capital gains tax is truly a wealth tax. Seeing as individual tax payers are taxed differently depending on their income (high income households face 23.8% taxation vs. 10% in others) the capital gains tax is a wealth tax. Investors in lower tax brackets win with dividend stocks and taking regular capital gains, much like investors in high tax brackets receive more from municipal bonds and MLPs.
- A Metals Tax – One of the many reasons gold and silver make poor long-term investments is because of they are taxed as collectibles at income tax rates rather than more favorable capital gains rates. Uncle Sam really doesn't care for your investments in gold, silver, or fine art, and you'll pay dearly in taxes for investing in any of the three.
Wise Up in 2013 or Pay More in Taxes
There's a clear cut answer to higher capital gains taxes in 2013:
- Consider very carefully taking any profits in individual stocks if the alternatives are not substantially better.
- Move money into tax-advantaged accounts, especially if you're invested in dividend paying stocks, or stocks which you do not intend to hold for a very long period of time.
- Rebalance by adding funds to realign your portfolio rather than taking profits and moving funds from one asset class to another.
- Evaluate very carefully the role of inflation in your investments and how it impacts the taxes you pay on returns.
Capital gains taxes will likely keep going higher. It's time to seriously think about smarter tax strategies to keep more of your returns in your own pocket.