How To Prepare For Higher Taxes Now (Before It’s Too Late)
As you know, we generally try to avoid political discussion here at StreetAuthority. That is unless it intersects with our holdings – which is all too often these days.
The White House and Congress can (and often do) exert considerable pressure on everything. From offshore drilling and pipeline construction to infrastructure projects to military spending to bi-lateral foreign trade deals. In turn, those policies affect the bottom lines of energy producers, defense contractors, manufacturers, and countless other businesses.
Stimulus packages. Monetary policy. Regulatory changes. They all reverberate from Main Street to Wall Street. So as investors, we must weigh the potential impact of government intervention and influence. That’s true at any time – but especially ahead of a Presidential election.
Which brings me to the subject I want to talk about today: taxes.
Get Ready For A Tax Hike…
If the polls hold true (they’ve been wrong before), then we could see some big changes coming to 1600 Pennsylvania Ave. None any bigger than the proposed tax hikes in Joe Biden’s platform.
It’s no secret that Biden intends to reverse the corporate tax cuts that boosted equity prices and helped fuel the market’s powerful 2016/2017 advance. He has also pledged to raise income taxes on high earners while also upping capital gains taxes from today’s 15% or 20% to as much as 40%.
The stated goal of the capital gains increase is to treat investment profits on stocks, mutual funds, real estate, etc. the same as ordinary wages. Ditto for qualified dividends; the preferential treatment would end. That’s particularly troublesome for income investors like you and me who rely on dividend income.
In short, the government charges a fee for price appreciation in your portfolio – and depending on your income level, that fee could double.
I’ll let the politicians debate the overall merits of corporate, personal, and capital gains tax increases. But from an investment standpoint, they are demonstrably bearish. And I wouldn’t be doing my job without telling you they give me pause.
Collectively, investors are sitting on trillions in unrealized gains. If the tax on a $100,000 profit is set to rise from $20,000 to $40,000 in 2021, most will choose to cash out and sell before the new rate takes effect.
That’s exactly why we historically see a rushed selloff preceding capital gains increases. It most recently happened in 2012. And this proposed increase would be the biggest in U.S. history, potentially triggering a wave of “beat the clock” selling.
This brings us to the heart of the matter – how this may affect your portfolio, and what you can do about it.
As you may know, there is a solution to higher taxes on capital gains and dividend income.
I’m talking about municipal bonds, which are exempt from federal income taxes (and often state and local taxes as well).
This asset class is garnering a lot of attention these days – and I fully expect that to continue.
“It’s all about what you keep…”
It’s right there on line 2B of your 1040 tax return. That’s where investors must report any taxable interest earned during the year.
If you’re in the 37% tax bracket, then 37 cents from every dollar of interest must be remitted to Washington. That cruel math means for every $10,000 earned during the year, you’re forced to hand over $3,700 on April 15, keeping just $6,300.
That interest might have come from a government bond fund with a yield of 2% or maybe a corporate bond ETF paying 3%. That’s not much to begin with. But on an after-tax basis, those payouts sink to just 1.26% and 1.89%.
This scenario isn’t merely hypothetical. Virtually every fixed-income investor must return a portion of their earnings each year — even those with a simple interest-bearing bank savings account.
But municipal bonds can help keep the taxman out of your pocket, while also reducing your exposure to market volatility.
Consider these two investment choices:
— Texas Transportation Comm. Highway Bonds, AAA-rated, maturing April 2025 with a 4.3% current yield
— Goldman Sachs notes rated ‘A’ maturing Jan 2024 with a current yield of 5.4%
Without knowing anything more, which would you choose? Both of these short-term debt securities are backed by solid investment-grade issuers. But in terms of upfront yield, it’s no contest.
The Goldman Sachs bond pays out $54 for every $1,000 invested, versus $43 for the Texas muni. But then tax time rolls around… For upper-income investors, that pre-tax income of $54 suddenly becomes an after-tax income of $34 (even less if state and/or local taxes are due).
But you owe nothing on the Texas bond. As a municipal agency, the interest it pays is untouchable. I think we’d all rather earn $43 than $34. So on an after-tax basis, the muni bond is clearly superior to the taxable bond.
The question is, by how much? That’s actually pretty simple to figure out, using the formula below.
Tax-Equivalent Yield = Muni Yield / (1 – Your Federal Tax Bracket)
If we plug in the numbers, then it looks like this:
4.30/(1-0.37) = 6.82%.
In other words, if you started with a rate of 6.82% and surrendered 37% of the income to taxes, then you would be left with the same 4.3% offered by the Texas muni. Therefore, it is said to have a tax-equivalent yield of 6.82%.
In essence, this is what a taxable bond would need to yield to match the payout on the tax-free bond. Or, from another perspective, the difference in quoted yield and tax-equivalent yield represents the muni’s tax savings to investors.
Ignore The Math At Your Own Peril
Cutting the IRS out of the loop can make a big impact on your portfolio (particularly when dealing with larger dollar amounts).
Let’s compare a $100,000 initial investment in a taxable bond fund yielding 5% and a comparable muni fund paying 4%. The corporate bond fund would generate $5,000 in annual interest. But when April 15 rolls around, Uncle Sam will take his share, reducing the income to just $3,150.
Meanwhile, the muni fund would throw off $4,000 in pure tax-free income.
That might not sound like much of a difference. But we’re talking nearly a full percentage of after-tax yield. Compounded over 10 years, the muni fund would accumulate to $148,024, versus $136,362 for the taxable fund — putting almost an extra $12,000 in your pocket.
Between you and me, I can think of plenty of ways to spend those tax savings.
Muni Funds Can Put More Cash In Your Pocket
Of course, like any asset class, supply and demand play an important role. And like any unfamiliar asset class, choosing which one can be a tall task. For this reason (as well as for diversification purposes), I prefer to leave that job to the pros.
That’s why, over at High-Yield Investing, I recently recommended a muni-bond fund that offers a one-stop shop for exposure to this corner of the income world.
Given the ominous threat of higher taxes, investor dollars will be flowing freely into the muni sector. Another round of economic stimulus and/or additional fiscal support from Congress to state governments would only add to the appeal.
With veteran leadership, a deep research staff, and best-in-class long-term returns, my recent recommendation will make the most of it.
Regardless of whether you’re a subscriber or not, this is one asset class I strongly encourage you to look into before it’s too late. If a tax hike does indeed come, you’ll be glad you did.
In the meantime, to learn more about what we’ve been doing over at High-Yield Investing, go here now.