February 13, 2013

The American Taxpayer Relief Act of 2012, the compromise bill passed on January 1 to deal primarily with tax aspects of the fiscal cliff, provided investors an element of certainty heading into 2013. The tax changes were permanent and mostly affected those in upper income levels:

  • The American Taxpayer Relief Act: Increases the maximum tax rate on dividends and long-term capital gains from 15% to 20% for those with taxable income above $400,000 for single filers and $450,000 for those filing jointly, and the top income tax rate for income above these levels increases from 35% to 39.6%.

    These income thresholds include dividends, interest, and capital gains and other income in addition to earned income.

Medicare surtax under the 2010 Affordable Care Act, known as "Obamacare," also goes into effect this year:

  • The 2010 Affordable Care Act levies a new 3.8% surtax on high earners who have "net investment income," which includes dividends and capital gains as well as bond interest. The tax is imposed on the lesser of the total net investment income or the amount of modified adjusted gross income (MAGI) in excess of the income threshold—$250,000 for married couples filing jointly or $200,000 for single taxpayers.

    For example, assume a single investor has $270,000 total MAGI in 2013, of which $45,000 is "net investment income." The investor must pay a 3.8% surtax on the lesser of $70,000 (the amount over $200,000), or $45,000. In this case, the tax applies to the $45,000, totaling $1,710 (i.e., 3.8% x $45,000).
How T. Rowe Price Investment Professionals View Taxes

While some high-income investors may want to review their taxable versus tax-exempt investment strategies and retirement programs, the higher tax rates should not be cause for fundamental changes to their long-term investment plans. The following analysis and insights reflects the views of our economic and investment professionals as of February 13, 2013.

Investments That Help Minimize Taxes

High-income investors affected by the rise in the top income tax rates and the 3.8% Medicare surtax might consider strategies that could help minimize their impact, though an investor's fund selection should be guided primarily by long-term goals and risk tolerance more than tax considerations.

  • Municipal bond funds, which provide income exempt from federal taxes and in some cases state taxes as well, could be even more appealing now. For an investor in the new 39.6% tax bracket, a muni bond fund yielding 4% equates to a taxable bond yield of about 6.6%, well above comparable Treasury yields. If the investor were also subject to the new 3.8% surtax, the taxable equivalent yield would be about 7%. However, future tax reform could include restrictions on tax-free municipal bond income for those in higher tax brackets.

    Taxes are always a big part of what drives interest in the municipal market, and with increased tax rates and no change in the municipal tax exemption, fixed income professionals expect to see continued strong demand from investors for tax-free muni bonds.

    Some municipal bond fund income may be subject to state and local taxes and the federal alternative minimum tax. Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative.
  • Tax-efficient equity mutual funds offer another potential opportunity to reduce greater tax exposure, because these funds are managed to minimize capital gain and dividend distributions to shareholders. Similarly, index funds, due to their passive management, tend to have relatively low turnover, which typically means minimal taxable capital gain distributions.

    These securities are subject to market risk, and share prices may be more volatile than those of slower-growing or cyclical companies.
Tax Implications for Equity Investors

While some analysts warn that equity prices, and particularly relatively riskier assets such as small-cap stocks, may be pressured by the boost in the capital gains rate, the past three decades of market history suggest that tax rate changes have had relatively modest effects on equity valuations and dividend policies. Moreover, investors should not focus on any short-term effects on the markets. In the long run, stock prices are more driven by such fundamental factors as earnings, interest rates, and economic growth than tax changes.

  • Historically, the overall impact of tax rate changes on equity returns and valuations appears to be modest. This observation is based on eight changes in the top tax rate on dividends (including the pre-2003 changes when dividends were taxed at the same rate as ordinary income) and four changes to the top long-term capital gains rate since 1980.

    In fact, the S&P 500 Index soared 27.7% in the 12 months following the 1990 increase in the maximum dividend tax rate (from 28% to 31%) and it gained 5.3% in the 12 months after the 1993 dividend hike (from 31% to 39.6%), according to market research firm Strategas Research Partners. Of course, past performance cannot guarantee future results.
  • It is inherently difficult to measure the impact of tax rate changes as markets react to many different factors, such as the 1990s technology bubble and the recovery from the 2000–2002 and 2007–2009 bear markets. Indeed, the capital gains rate in August 1981 was reduced from 28% to 20%, yet the S&P 500 declined 14% in the following six months amid double-digit interest rates and a double-dip recession.
  • Higher tax rates could be somewhat negative for the stock market for a period of time, but the hike in the capital gains rate is not expected to disproportionately disadvantage small-cap stocks.
  • Small- and large-cap stocks should be relatively unaffected as long as dividends and capital gains continue to be taxed at the same rate. When dividends were taxed at a higher rate than capital gains, small-caps were relatively advantaged; in some respects, that was the golden age for small-caps.
Do Tax Rate Changes Favor Non-dividend Stocks?

With dividends and long-term capital gains continuing to be taxed at the same rate, there is no inherent tax advantage, for example, in favoring growth-oriented stocks over those that provide relatively high or growing dividends. Still, higher tax rates could cause some companies to revise their dividend policies, affecting payout ratios and yield, according to investment  professionals.

  • For dividend stocks, economic environment is more critical than tax rates. In a slower growth world, like today, there's a case for dividend-oriented stocks to hold their own because they tend to be defensive, and the dividend portion of your return is more assured than capital gains.
  • Dividend-paying stocks typically do less well when the economic environment is stronger and risk taking is more prevalent—none of which is evident today. Investors should not abandon their long-term investment strategies in reaction to slightly higher rates. In addition to offering relatively attractive yields, companies with the ability to grow dividends over time tend to be high-quality companies with strong cash flow and relatively predictable earnings. Dividend stocks can provide a growing stream of income to hedge against inflation.
  • Tax-exempt and tax-deferred investors may reduce the market impact. Standard & Poor's estimates that up to two-thirds of dividends from S&P 500 companies—and as much as half of all other U.S. equity dividends—are paid to tax-exempt investors (such as public and private pension plans), tax-deferred investors (401(k) plans and individual retirement accounts), or foreign nontaxable investors. Such investors tend to be less sensitive to tax rate changes. To the extent that tax-exempt or tax-deferred investors are driving the market, tax rate changes should have minor impact on valuations.
  • The new 20% rate on the margin should have only a modest negative impact, and not necessarily for those companies that have a long history of growing dividends that have lived through various tax policies. If the dividend tax rate had reverted to ordinary income tax rates, with a top rate of 39.6% along with a lower capital gains rate, that could have significantly affected dividend policies of some companies.
  • Over the longer term, tax rates do appear to have influenced corporate dividend decisions. However, analysts say these effects appear to be extremely gradual, as companies are reluctant to cut dividends because that typically is viewed negatively by the market.
How Should Bond Investors View Tax Hikes?

The higher tax rates and prospective spending cuts and debt ceiling outcome could have a greater impact on fixed income:

  • The markets dodged a bullet, but uncertainty remains. Credit markets were expected to be more volatile than they've been. In the third quarter of 2011, debt ceiling discussions were not good for the markets.

    Then, yield spreads widened across credit sectors and a broad, global sell-off across risk assets occurred. Ironically, the U.S. Treasury market rallied after the U.S. credit downgrade following that debt ceiling fight as investors fled to perceived safety. Investors should not expect Treasuries to rally again if that history is repeated.

    The 10-year Treasury was yielding about 3%, and that flight to safety brought them down to 2%, where they've stayed. Today, there is a lot less room for Treasury rates to go down. But if negotiations become contentious and it looks like no deal will get done, rates could go down a little more. Treasury rates did go up this month on the fiscal cliff relief rally.
  • High yield bonds could suffer if the higher tax rates and potential spending cuts slow the economy more than expected. The market is pricing in perfection, so there is not a lot of margin for error and there is more risk to the downside if we get further progress on fiscal policy.
  • Munis are supported by strong demand from individual investors, particularly those subject to higher tax rates and the new 3.8% Medicare surtax. Municipals continue to offer attractive taxable equivalent yields, especially for those facing a maximum income tax rate now of about 43%, as opposed to 35% before. Although absolute muni yields may look low, new tax rates make them more competitive with other markets.