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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 ….
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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.
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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.
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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%)
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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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