This Could Cause the Next Crash

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In a perfect world, taxes would have absolutely no impact on the way you invest your money. With all the tax incentives and burdens that investors have to look at, however, weaving through the ever-changing tax laws to find the best ways to keep more of your money is a constant battle -- and one that requires you to be constantly vigilant.

What's coming
Within less than a year, the entire tax landscape for workers and investors may go through a dramatic transformation. Consider where we'll be 12 months from now if Congress can't agree to changes in existing tax law:

  • Rates on capital gains for investments held for longer than a year will rise from their current maximum of 15% to 20%.
  • For taxpayers in the lower tax brackets of 15% or less, a 10% capital gains rate will replace the current 0%.
  • Qualified dividend income from certain stocks will no longer have the same preferential rate as capital gains. Instead, investors will pay tax at the same rate they pay on other types of investment income, such as interest on bonds and bank CDs.
  • With 2001 tax rates returning, tax rates as high as 39.6% will apply to wage and investment income, and taxpayers at all levels could see marked increases in the amount of tax they have to pay.

As if these taxes weren't enough, the government is considering new taxes to help pay for various legislation, such as health-care reform. High-income taxpayers face a number of possibilities, including a 5.4% income-based surtax and a hike in the amount they have to pay in Medicare taxes. One proposal has suggested imposing the Medicare tax on investment income, including dividends. In addition, some particularly comprehensive health insurance plans that employers provide could lose their tax-free status, forcing workers to treat part of their value as taxable income.

Unintended consequences
As we've seen so many times already during the financial crises of the past two years, the actions that the government and others have taken often do more than what you'd think at first glance. Just this week, Congressional leaders are seeking more information from the New York branch of the Federal Reserve about whether it intended the funds that went to beleaguered AIG (NYSE: AIG  ) as a "backdoor bailout" of its counterparties, which reportedly included Goldman Sachs (NYSE: GS  ) and Deutsche Bank (NYSE: DB  ) among others.

Similarly, while higher taxes would potentially address the troublesome increase in the budget deficit since the market meltdown began, they could easily have effects that might cascade into big problems for the financial markets. In particular:

  • Significantly higher taxes on dividend stocks like Coca-Cola (NYSE: KO  ) and Southern Company (NYSE: SO  ) could lead some investors to sell off their shares. That could drive share prices down, thereby hurting the conservative investors who rely on them for income and capital preservation -- especially at a time when it's difficult to find investment income from other sources.
  • Coming increases in capital gains taxes could lead investors to cash in their recent big gains on stocks like Google (Nasdaq: GOOG  ) and Ford Motor (NYSE: F  ) late this year in order to get in under the wire with current low rates. The resulting selling pressure could easily throw the market into chaos if uncertain investors aren't sure whether buying those shares would be a smart tax move.
  • Although higher taxes generally might encourage more investors to use tax-favored investment vehicles like IRAs and 401(k) retirement plans, they might also raise even more concerns that the government could take drastic steps to increase tax revenue, such as changing existing law to impose taxes on currently tax-free investments in Roth IRAs.

History suggests that these tax increases could hurt the economy at its most vulnerable moment. During the Great Depression, the U.S. saw significant tax increases throughout the 1930s -- at a time when national and local governments saw exactly the same fiscal pressures they're experiencing today. Although the temptation to increase spending in times of need is almost irresistible, imposing new taxes on investment so soon after the world's entire investment capital infrastructure was put in jeopardy seems foolhardy at best.

Higher taxes are coming
Unfortunately, the nation's financial situation doesn't leave it with many alternatives. In all likelihood, at least some tax increases will affect investors. Whether they lead to another wave down for the financial markets remains to be seen -- but you should remain on your guard to ensure that you protect your wealth as well as you can from the resulting consequences.

For more on how to save the most on your taxes, be sure to check out our Tax Center throughout the filing season.

Fool contributor Dan Caplinger hopes for the best but plans for the worst. He doesn't own shares of the companies mentioned in this article. Coca-Cola is a Motley Fool Inside Value recommendation. Google is a Motley Fool Rule Breakers pick. Ford Motor is a Motley Fool Stock Advisor selection. Coca-Cola and Southern Company are Motley Fool Income Investor recommendations. Try any of our Foolish newsletters today, free for 30 days. You'll never get hit with a tax from the Fool's disclosure policy.

Read/Post Comments (14) | Recommend This Article (24)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 13, 2010, at 12:41 PM, Fool wrote:

    Do you really think raising the Capital Gains tax from 15% to 20% will change investors' habits?

  • Report this Comment On January 13, 2010, at 1:24 PM, BobSea wrote:

    If you buy/sell stocks for or because of taxes then you should not be in the market.

  • Report this Comment On January 13, 2010, at 3:42 PM, Happyman584 wrote:

    Dan, you were really short of ideas today weren't you? You are not serious that you think these scenarios would cause a crash, are you? Nothing described herein is is even beyond incremental, if they change at all.

    frankly, these changes (5% bumps and such) would post a floor under the dollar, which is very much needed, and help manage the very scary crash scenario of foreign investors deciding not to show up at treasury auction one day.

  • Report this Comment On January 13, 2010, at 5:14 PM, langco1 wrote:

    we are just starting our second year in a depression lets get past this crash before we talk about the next one....

  • Report this Comment On January 13, 2010, at 5:30 PM, Intlinvstr4life wrote:

    Perhaps a different perspective...

    Investing 103

    Try adding a 5% discount rate to a future value projection over 10 years.

    Result: a 40% reduction in total future value after 10 years.

    That's right; same amount of time, effort, and risk spent on investing with half the return.

    The devil is in the details on this one. Some one wants you to think "IT'S ONLY 5%"

  • Report this Comment On January 13, 2010, at 6:36 PM, rfaramir wrote:

    I don't know about "Cause the Next Crash" but prolonging this Greater Depression, yeah. All the government tyranny you mention will make matters worse for us all. It always does, but at this juncture, we certainly cannot afford it.

  • Report this Comment On January 13, 2010, at 8:59 PM, Fool wrote:

    So, you don't raise taxes during a recession.You lower taxes when its just slow. You don't raise taxes when the economy is going, not to upset the good times. You then complain about the budget deficits. Also, forget saving a surplus the last 40 years for the coming baby boom retirement. So, could you tell me when did you recommend a tax hike? Oh yeah, you're like all the politicians that ever ran on, "we just need to take the waste out of government." That worked... RE Bear

  • Report this Comment On January 13, 2010, at 10:33 PM, jpdewy67 wrote:

    Always and everywhere, without exception taxes depress economic activity and growth.

    Always and everywhere, without exception people respond to incentives and disincentives. As taxes are raised the incentive to invest is discouraged because the after tax ROI is reduced. Why is there any debate about the effect of increased taxes?

  • Report this Comment On January 14, 2010, at 4:13 AM, xetn wrote:

    There is also a lot of talk about making the tax increases retroactive to 1 JAN 2010, which means, if it happens, it is too late to do anything about it.

    The right thing for the government to do at this point (they should have done it in the first place) would be to drastically cut spending and taxes.

    Every single dollar the government spends is one less dollar available for the private sector.

    The only growth in jobs last year was a in government.

  • Report this Comment On January 14, 2010, at 10:01 AM, BMFPitt wrote:

    "The right thing for the government to do at this point (they should have done it in the first place) would be to drastically cut spending and taxes."

    Cutting taxes while running a deficit is generational theft. Taxes should not be cut until we have enough of a surplus to pay for those cuts in the current fiscal year and without any accounting shenannigans.

  • Report this Comment On January 17, 2010, at 2:50 PM, Classof1964 wrote:

    Our taxes our at the lowest rates we have had for decades. The tax cuts in the previous administration did several things: squandered the surplus that had been built up in the 1990s, bankrupted the federal government, balloned the national debt, and gave the disproportionate share of tax cuts to the wealthiest Americans, 5% or less of the tax payers, particularly the top 1%.

    Taxes are what pay for civilization. Frankly our country is in serious peril over the long term. The Congress has repeatedly failed the people by caving in to special interests at the expense of the majority, who do not shower our representatives with targeted campaign contributions. Government is strangled by the mindless "NO new taxes" camp and by the failure to legislate for the common good. Take the failure to pass real reform of the financial sector for starters. Consider the games played to hide the unproductive spending by Congress: ear marks, Social Security Trust Fund (=IOUs), military expenditures off budget, etc.

  • Report this Comment On January 17, 2010, at 2:58 PM, goalie37 wrote:

    I hate to think of Barney Frank having access to more of our money.

  • Report this Comment On January 20, 2010, at 9:27 AM, crayx wrote:

    I feel like screaming when the selfish,do not tax me tax someone else or borrow from the kids and do not cut any government benefit I get including medicare crowd hollers that they will invest less if the people raise taxes on the sit on our butt and collect dividendsfolks while the real workers get taxed at triple that rate. What a farce. All civiilizations fail. This one will too.

  • Report this Comment On January 21, 2010, at 11:34 AM, FuzzySideUp wrote:

    Obama will be a 1 term president

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