Are Taxes More to Fear Than a Market Decline?

BOSTON (TheStreet) -- Investors are jittery about the stock market's decline to a 10-month low earlier this month, and many are piling into bonds. But they may have more to lose in the form of higher taxes.

Although a dip in stocks is immediately felt in investment and retirement funds, new and increased taxes could inflict a far-reaching and long-lasting erosion of assets. Is, for example, a temporary 25% drop in stock prices any better or worse than having profits slashed in equal proportion by the tax man?

"Market cycles come and go but tax rates can stay for a very long time," says Ron Florance, director of asset allocation and investment strategy at Wells Fargo's(WFC) private-banking unit. "One of the things investors need to look at is that what you earn in your portfolio isn't really that important. What you earn after you pay your taxes is what determines your lifestyle."

An advisory to Wells Fargo clients referred to the past few years as the "Golden Age" of taxation for investors. Since 2003, when the federal income-tax rate on dividends and long-term capital gains were reduced to a maximum of 15%, concern about tax rates disappeared. With Bush-era tax cuts set to expire at the end of this year, it is again time to focus on strategies that defer capital-gains taxes or shelter dividend income.

It is still unclear which taxes will increase and by how much. But heading into next year, there are some likely scenarios, especially if Congress takes no action to extend sunsetting rates.

The Obama administration's budget proposal -- confirmed Wednesday by Obama's secretary of the Treasury, Tim Geithner, on CNBC's The Kudlow Report -- calls for the rate on long-term capital gains to return to 20%, up from 15%, with short-term capital-gain rates remaining at the taxpayer's marginal ordinary income-tax rate. Qualified dividends no longer will be taxed like capital gains, but instead be treated as ordinary income. For those in the highest brackets, the rate returns to 39.6% from 15%.

Health-care reform adds a 0.9% surtax on self-employment income for single taxpayers making more than $200,000 and couples earning more than $250,000. There is also a 3.8% Medicare surtax on investment income (including interest, dividends, capital gains, annuities, royalties and passive rental income) for individuals with adjusted gross incomes above $200,000.

There is also a likelihood that marginal rates on ordinary and investment income will rise, but sweeping changes in these rates over the years makes a prediction difficult. In 1963, the rate was 91%, cut to 77% the following year by the Kennedy administration. In 1981, the rate was 70%. Since 2003, the rate has been at, or below, 35%.

What will happen on the estate-tax front is anybody's guess. In 2009, the rate was 45%. The tax was dormant in 2010 but, by 2011, barring Congressional action, the rate returns to 55%. As the rate rises, the exemption will also probably drop. Last year, the exemption meant that only an estate valued at $7 million or more would trigger the tax. Next year, the threshold could be as low as $2 million.

"Many people with a paid-off house and a retirement plan will hit that," Florance says. "It is a very big change."

While America awaits tax guidance that will probably not come before midterm elections, there are tax-hedging strategies to start considering.

Converting traditional IRAs to Roth IRAs by the end of this year will lock in the current tax rate.

If you are considering disposing of a long-term investment, or recapitalizing a business interest, it may be better to realize the gain now than wait until next year or later when capital-gains rates will be higher.

Adding municipal bonds to your portfolio can also provide needed tax advantages.

Still, the worries may be overstated. As a recent article by Evan Simonoff for Financial Advisor Magazinepoints out, Ronald Reagan's decision to increase the tax rate on capital gains to 28% from 20% starting in January 1987 did little to impair the markets, even if the run-up to the increase gave rise to an era of corporate raiders. The Dow started the year at 1,897 and ballooned to 2,700 by the end of August, although some of those gains can likely be attributed to Reagan's parallel move of lowering the highest marginal tax rate on income to 28% from 50%.

The Clinton administration advocated higher taxes on the wealthy. The move away from the Reagan-era philosophy of focusing cuts on the top marginal rates was predicted to be disastrous for financial markets. Instead, the federal deficit was reined in, more than 18 million jobs were created, inflation slowed and falling interest rates kick-started the housing boom.

President George W. Bush's subsequent pitch for the $1.6 trillion in tax cuts now expiring was that they would create jobs and spur economic growth. Instead, job losses numbered in the millions, and the Clinton administration's annualized stock returns of 19% far outshone the 0.9% drop of the Bush years.