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:

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.