HOT: If capital gains tax rates go up 8.8%, how much will after-tax capital gains ROIs go down?

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Well, Obama says he’ll jack capital gains tax rates from 15% to 20% … and ObamaCare has a 3.8 non-payroll payroll tax on investment income starting in 2013.

So, if Obama is elected and he keeps his promise … the effective capital gains tax rate goes from 15% to 23.8% … a delta of 8.8%.

That 8.8% tax rate increase will cut after-tax capital gains ROIs.

By how much?

Answer: The pre-tax ROI times 8.8%.

In other words, the answer depends on the proportion of a stock’s value that is unrealized capital gains.

The answer isn’t intuitive and the math is a bit hairy, so let’s run thru an example ….

* * * * *
Scenario 1 – CG Tax = 15%

Assume that you bought a stock for $750 and sold it for $1,000 … netting a $250 pre-tax gain.

The pre-tax ROI is 33% … $250 divided by $750.

If the capital gains tax is 15%, you pay $37.50 in taxes … netting you, after taxes, $212.50.

The after-tax ROI is 28.3% … $212.50 divided by $750.

* * * *  *
Scenario 2 – CG Tax = 23.8%

Again assume that you bought a stock for $750 and sold it for $1,000 … netting a $250 pre-tax gain.

The pre-tax ROI is still 33% … $250 divided by $750.

If the capital gains tax is 23.8%, you pay $59.50 in taxes … netting you, after taxes, $190.50.

The after-tax ROI is 25.4% … $190.50 divided by $750.

* * * * *
The Difference

The CG-ROI @15% is 28.3%, where CG-ROI @ 15% is the Capital Gains ROI at a 15% Tax Rate.

The CG-ROI @23.8% is 25.4%, where CG-ROI @ 23.8% is the Capital Gains ROI at a 23.8% Tax Rate

The difference is 2.9% … that is, the CG-ROI dropped by 2.9 percentage points.

Note that 2.9% is equal to the pre-tax ROI (33%) times the difference in the tax rates (8.8%)

* * * * *
The generalizable answer

By math magic, the difference in after tax ROIs  are always equal to the pre-tax ROI (which varies depending on the relationship between a stock’s unrealized capital gains and its cost basis) times the difference in the tax rates (in this case, the 8.8% difference between  15% and 23.8%).

If you’re interested, click to view the math work …  if you’re not, skip to the table below.

Here’s a handy look-up table.

UR-CG are unrealized capital gains as a percentage of current stock market value.

In the above example, UR-CG equals 25% … $250 pre-tax capital gains divided by stock’s current market value $1,000 … and there’s a 2.9 percentage point drop in ROI.

As you’d expected, the greater the percentage of capital gains embedded in a stock, the greater the ROI hit if marginal tax rates go up.

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* * * * *
So what?

I don’t give investment advice, but the numbers say that if you expect Obama to be re-elected … and if you expect him to keep his promise and jack up capital gains tax rates … and you have stocks with a high proportion of embedded capital gains … you should probably consider selling.

Technical tax note: Wash sales rules don’t apply to stocks sold at a gain … that is, you can sell them pay the capital gains taxes and immediately buy them back at a stepped-up basis (i.e. the current market price).

In a subsequent post I’ll work thru the math re: whether that makes sense.

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