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How Will November Affect Your Portfolio?

It's far too early to guess who'll win the election in November. But it's never too early for investors to worry about what impact it could have on the stock market -- especially when it comes to proposed tax changes.

Over the years, investors have seen a number of favorable tax changes come their way. Accounts like IRAs and 401(k) plans give investors huge opportunities to grow their retirement savings while deferring taxes. Meanwhile, tax rates on capital gains have steadily come down from 28% following the 1986 tax reforms to their current maximum of 15%. More recently, stock dividends became eligible for that lower 15% rate as well, cutting taxes for high-income taxpayers by 20 percentage points.

Both presidential candidates have proposed changes to the current tax laws. Among the proposals are hikes in both the ordinary income rates that top-bracket taxpayers pay on most of their income as well as increases in the more favorable tax rates for capital gains and stock dividends that investors enjoy.

Needless to say, both of these prospective changes could have a big impact on your retirement.

Higher rates on ordinary income
Although a general tax increase would create a heavier tax burden for interest on bonds, CDs, and other fixed-income investments -- which are taxed at the prevailing ordinary income rates -- the proposed increases aren't huge: Tax on the highest tax bracket would rise from 35% to as high as 39.6%.

Although modest, these slightly higher tax rates will affect how you save for retirement -- because it will be even more important to participate in tax-deferred saving through IRAs and employer-sponsored retirement plans. If you're eligible to make Roth IRA conversions, doing so during the current low-tax environment could create substantial tax savings.

You might also consider municipal bonds, which pay tax-exempt income. Falling local tax revenues, combined with credit-related issues at muni-bond insurers Ambac Financial (NYSE: ABK  ) and MBIA (NYSE: MBI  ) , have created some uncertainty for municipal bonds, driving some yields above those for taxable Treasury bonds. But those attractive after-tax yields will become even juicier with a tax increase.

Higher rates on capital gains and dividend income
More troubling is the proposal to raise taxes on the income that's most important for stock investors: dividends and capital gains. The current 15% rate could rise to 20%-25% or even higher -- and the fear of that hike may bring an avalanche of year-end selling.

Say, for instance, you own some stocks with nice gains, and you expect to sell them within the next few years in a taxable account. Look what happens if you wait to sell until a higher tax rate comes into effect:

Stock

5-Year Average Annual Return

Current Gain on $10,000 Investment in 2003

Tax If Sell Now

Tax If Sell At Higher Tax Rate

Halliburton (NYSE: HAL  )

26.7%

$22,709

$3,406

$4,542-$5,677

Potash Corp. (NYSE: POT  )

67.6%

$122,181

$18,327

$24,436-$30,545

Apple (Nasdaq: AAPL  )

69.8%

$131,126

$19,669

$26,225-$32,782

Amazon.com (Nasdaq: AMZN  )

11.7%

$7,386

$1,108

$1,477-$1,847

Research In Motion (Nasdaq: RIMM  )

77.9%

$168,247

$25,237

$33,649-$42,062

Source: Yahoo Finance. As of Sept. 8. Assumes $10,000 investment in each stock and tax rate increase to 20-25%.

Faced with the possibility of paying thousands of dollars more in taxes, many investors will sell sooner rather than later.

Whether or not you hold investments in a taxable account, these proposed tax changes may affect your investments -- because they affect other people's investments. If investors who sell assets at the end of the year reinvest in other stocks, the net impact on the overall market may be small. But if those investors choose not to reinvest in stocks -- not a crazy assumption, especially given how fearful many investors are right now -- then the extra selling pressure could prove to be the catalyst for further declines.

The Foolish bottom line
No matter who wins in November, the tax code is likely to get an update. And although taxes aren't the only thing you should consider in making investment decisions, ignoring potential tax changes can be disastrous to your finances.

If you'd like to find out more about how proposed tax changes could affect your retirement savings -- and what you can do to protect yourself -- consult the experts at our Rule Your Retirement service. Foolish retirement guru Robert Brokamp and his team cover the whole range of retirement topics, from making the most of IRAs and other retirement savings methods to making specific stock and fund recommendations. Click here for a free 30-day free trial -- there's no obligation to subscribe.

Fool contributor Dan Caplinger expects higher tax rates sooner or later. He doesn't own shares of the stocks mentioned in this article. Apple and Amazon.com are Motley Fool Stock Advisor recommendations. The Fool's disclosure policy is always above average.


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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 September 11, 2008, at 11:30 PM, RaulChapin wrote:

    An increase from 15% tax to 25% on capital gains and dividends is downright scary. Don't these candidates know that cash going into public companies and enterpreneurship is what fuels a healthy economic growth??!!

    Worse of all, this will really affect risky new technology stocks and those are the companies that keep the USA somewhat IN the race for technological superiority.

    While blind pseudo-investing to get fairy tale capital gains can lead to bubbles like the housing marked one, it is the investing in growth stocks which lies at the very base of creating the much needed jobs. Making cars is much cheaper in China... making everything is much cheaper out of the USA, the only way to mantain the USA way of life is by keeping the technological advantage and that needs money... money in the growth stocks, not in the cash cows and the certificates of deposit.

    Of course in the short term what this means is that there is less incentinve to save and more to spend, which of course for short sigthed "we want to look good now" politicians seems like a wonderful idea. I have no idea what Mcain thinks of investing in enterpreneurship (IE the stock market) but Obama has already made his point of considering it a gamble.

    While I am not a USA citizen, I am not blind to the fact that a falling giant can damage a lot of its neighbours. I hope that this is just another lie from politicians wanting to appeace the masses who think that they will benefit from "Taxing the rich"

  • Report this Comment On September 12, 2008, at 1:53 PM, CAthinker wrote:

    Since the author did not mention either of the candidates or their platforms, I will not either. But, I must point out that only ONE of the candidates is proposing a tax increase on dividends and capital gains.

    The other candidate wants to keep the capital gains and dividend tax rates to help encourage Americans to save.

    Only one candidate also proposes getting rid of the AMT (Alternative Mininum Tax) ... a tax that will be paid nearly exclusively by 25 million middle class families. This tax usually creeps in when both spouses are working.

    Only one candidate also proposes to cut the corporate tax rate from 35-25 percent so that American companies can compete more fairly with foreign companies who enjoy lower corporate tax rates. The American public wins because corporate taxes are usually passed to either stockholders or consumers. This will help more capital to be applied towards research and development.

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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