There's Nothing Certain in Life Except...

The old adage goes, "There's nothing certain in life except death and taxes". Today, I'd like to say that there's nothing certain in life except death and tax law changes!

2010 has proven to be a politically volatile year and much of the debate around the country today centers on tax policy. As it stands, President Bush's tax cut package in 2003 is set to revert on January 1, 2011 so that everything from higher marginal income tax rates, as well as dividends and capital gains tax rates are all set to increase if Congress doesn't act before the end of the year to extend them.

From the Gen Y investor's standpoint, the news is very disheartening because both dividends and capital gains taxes could be on the rise. Today, the top tax rate on capital gains is 15% (and most likely less for millennials in lower tax brackets) and this figure would rise to 20% in 2011 if nothing is done to extend the tax cut, or make it permanent. On the other hand, dividends taxes are currently maxed out at 15% and will rise to 39.6% next year if nothing is done by Congress.

Why This Matters: A capital gain occurs when you sell a capital asset for a higher price than you purchased it. When you do this, you trigger a taxable event that will result in a payment to the IRS the April after you sold your asset. On the other hand, dividends are distributions made by a company out of their net income. In the U.S., companies experience double taxation of dividends - when they earn their income and when shareholders report their personal income (even though the amount is from the company's after-tax earnings).  Higher capital gains and dividends taxes discourage investment because more of the capital that should be flowing to you is instead flowing to the government. This in turn hurts economic growth because less capital is in the hands of investors who could use it to stimulate economic activity with spending.

With upwards of 60% of American households now owning stock, bonds, mutual funds or the like, higher capital gains and dividends taxes will affect all classes of people. Millennials will be hit especially hard because our long-term investment horizons will now have less of a capital base to compound upon as we pay more in taxes. For example, assume that you pay taxes at the highest marginal rate and earning $5,000 in dividends this year. Come April, you will cut a check to the government for $750 so you take in $4,250 after-tax. Next year, you would only take in in $3,020 as you will have to pay a 39.6% dividend tax!

What to Do: While the tax changes going into next year are still quite uncertain, if you are sitting on a large capital gain or two, consider selling some of your position so that you will pay a lower rate on that gain this year. However, make sure the capital gain can be classified as long-term (the security is held over 1 year), otherwise, you may have to pay even more. As for the potential dividend tax increase, it may be a good idea to hold any serious income-producing investments in a tax-free Roth IRA so that you will be shielded from a potential tax increase going into 2011.