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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.
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.
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.