The Buffett Rule and How it May Affect You

04/16/2012

Tax Rates on Investment Income Likely to Go Up

Article by ISI - International Strategy & Investment

Senate Republicans derailed the Fair Share Tax Monday, that would require the nation's top earners to pay at least 30% of their income in taxes.

By a near party-line tally of 51-45, senators voted to keep the bill, often called The Buffett Rule after billionaire investor Warren Buffett alive, but fell short of the 60 needed to continue debating the measure.
President Obama has said the Buffett Rule is a principle for tax reform. He now favors a top tax rate on capital gains of 30% and a top rate on dividends of 43.4%. If he wins reelection, and Democrats hold on to the Senate, tax rates on investment income could go up substantially.

Even under a GOP victory, tax rates could go up both because Republicans may not be able to fully extend the Bush tax cuts. Also, under Obama’s health care law a 3.8% tax on investment income for upper-income taxpayers kicks in next year. So Republicans would have to fully extend the Bush tax cuts and repeal the 3.8% tax on investment income to keep the dividend and capital gains rate at 15%.

Under current law, the tax rate on dividends is scheduled to go from 15% to 43.4% because they would return to being taxed at ordinary rates (39.6%) plus the 3.8% surtax on investment income. The top tax rate on capital gains would rise under current law from 15% to 23.8% because they would return to the pre-Bush level of 20% plus the 3.8% surtax included in the health care law.

President Obama’s Buffett rule would effectively push the top capital gains rate to 30%. There are a small number of millionaires who pay effective tax rates much below 30%. They primarily earn their income from investments – in other words, they have capital gains and dividend income. But since Obama favors a 43.4% rate on dividends, the Buffett rule is really a backdoor increase in the effective capital gains rate.

Because of the severe budget problems facing the country and the higher rates that kick in under current law starting January 1, 2013, investors should expect the top dividend and capital gains rates to rise, even under a scenario where Mitt Romney wins and Republicans win majorities in the House and Senate.

Our bottom line would be to expect capital gains and dividend rates in the 20% range under a GOP sweep (with the rates likely to remain the same for both). In the unlikely event of an all-Democratic government (which Intrade implicitly puts at about one-in-three – far too high in our view), the top rates on investment income could be as Obama has proposed them. This means the differential would return with dividends taxed at higher rates (43.4%) than capital gains (30%) for upper income individuals.

If Obama wins reelection and the GOP maintains its majority in the House, control of the Senate will be critical to whatever tax compromise is reached. It’s also not clear if capital gains and dividend tax rates will remain equal to each other under the divided government scenario, although they probably will. The range under this scenario for both capital gains and dividend tax rates would probably be 20-30%, with the Senate and Obama victory margin playing a major role on which end of that range tax rates end up.

If you have questions about this article and how you will be affected by the Buffett Rule, give us a call to set up an appointment with one of our financial experts.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2011-2014.