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

Here’s an encore presentation of a HOT: Homa Online Tutorial originally posted before the election.

* * * * *
Well,  Obama got his dream to come true — capital gains rates have been jacked from 15% to 23.8% ….  the basic capital gains tax rate went  from 15% to 20% … and ObamaCare has a 3.8 non-payroll payroll tax on investment income starting in 2013.

So, 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%.

Here’s the math …

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%)

* * * * *

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. * * * * *
So what?

Those are serious drops in ROIs and – contrary to Buffett’s “only look at pre-tax” rule — it’s why many investors accelerated asset sales into 2012.

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

* * * * *