Financial Planning: What Higher Taxes Could Mean

What to consider if tax rates rise on everything from capital gains to restricted stock
Jacob Thomas

It's not something that makes good campaign politics. But given the crumbling economy and the federal government's budgetary needs, some Americans are likely to be hit with a tax increase regardless of who wins the Presidential election.

To be sure, there are vast differences in the tax plans of Barack Obama and John McCain. Obama's proposal calls for a bunch of middle-income tax cuts paired with an increase in the top marginal tax rates to 36% and 39.6% from the current top rate of 35%, to be paid by families with incomes over $250,000 and singles over $200,000. It would also increase the rate on those earners for long-term capital gains and qualified dividends to 20%, from 15%. McCain vows to extend George Bush's 2003 tax cuts on income and investments. (McCain recently said he would halve the cap-gains rate, to 7.5%, in 2009 and 2010.) Without new tax legislation, those rates are set to expire at the end of 2010. With a financial bailout to pay for and a potentially Democratic Congress, tax experts figure that rates on both income and capital gains will be in play over the next two years.

"The difference between the two [candidates] is not that Obama wants to collect more tax, but that he wants to collect it from different people," says Clint Stretch, director of tax policy at Deloitte in Washington. "One of the challenges is that both plans would collect less income tax [than is collected] today. In the Obama world, maybe fiscal discipline means some tax benefits he would give people don't come to pass. In the McCain world, maybe the extension of Bush tax cuts he proposes would not come into effect. It's really a question of how this gets bargained out with a Democratic Congress—if there is one—because if nothing happens then taxes go up."

It's unlikely that any tax plan will be pushed through quickly, so you have time to consider your options. Here are four ways you might be affected by higher taxes and some suggestions for thinking about the consequences.

CAPITAL GAINS

Common wisdom says to sell your winners if you believe rates will go up. Yes, it's obvious. It's also not always the best strategy. That's because you're paying taxes early, and you'll need to recoup that outlay as well as transaction costs through higher gains on your investment. "Those two things can outweigh the tax savings," Stretch says. "If you have an investment with a low cost basis and low transaction costs, then it may make sense to sell. If you have a high basis or your gain is in the 10%-to-20% range, it probably does not make sense. For most people you are talking about a reasonably small amount of money, and there are cases in which taking the gain is detrimental."

Let's say you own shares of Stock A that is now valued at $10,000, and your cost basis is $7,000. If you sell now, at the 15% rate, you'll pay $450 in tax. If you wait, and the cap-gains rate goes to 20%, you'd pay $600. Is that worth the potential $150 savings, especially after fees?

"The big question is, 'What are you going to put the money into? And will you earn enough more to recoup the taxes paid?' " says Robert Barbetti, an executive compensation specialist with J.P. Morgan Private Bank (JPM)in New York. According to his figures, it would take two years invested in something that offered an additional two percentage points in return annually to recoup the tax paid in the example above. To make the right decision, you need to think about what you're going to buy once you sell, and whether it offers enough extra return to be worthwhile.

COMPANY STOCK

With most 401(k) plans, if you've been laid off or are over 59 1/2 and eligible for distributions, there's a little-known opportunity to take company stock out of the plan and pay tax just on its cost basis. Here's how it works. Say you have 100 shares of stock in Company X that trades at $50, and your basis is $10. You would take the stock out and pay $350 in tax, assuming you're in the 35% tax bracket.

The difference between the $50 value and the $10 basis, or $40, for tax purposes is called net unrealized appreciation, or NUA, and is taxed at long-term capital gains rates regardless of when you sell. Even without an increase in rates, that's a nice savings. At a 15% capital gains rate, you'd pay a total of $950, instead of $1,750 if you had to pay income taxes on the entire distribution. If the marginal income tax rate goes up, that benefit becomes more valuable. Barbetti says that with more people being laid off, especially on Wall Street, he's been seeing increased interest in this tax move.

DEFERRED COMPENSATION

If you're lucky enough to have a deferred compensation plan, you know that the big benefit is tax deferral, which allows money to compound tax-free until it's withdrawn. That's valuable if tax rates remain constant or decline. Even if tax rates went up as high as 50%, much higher than anything under consideration, deferring compensation would still make sense over the long haul. You might want to reconsider deferring compensation if you expect rates to rise at the time you want to take your money out.

You'll need to think about this in advance. If you want to defer base salary and nonperformance-based bonuses earned in 2009, you will need to elect to do so by this Dec. 31. Once you choose to defer, you can't change your mind and take the money out of the plan sooner.

RESTRICTED STOCK

If you've been offered restricted stock, you should think about taking the 83(b) election. That election, which must be made within 30 days, allows you to pay the income tax up front and pay tax on future gains at the lower cap-gains rate. If you don't make the election, you pay tax when the stock vests, regardless of whether you sell it. If the stock goes up dramatically before it vests, you'll save yourself a hefty amount of cash by choosing the 83(b).

But if the stock remains flat (or worse, declines), you may have paid tax (or, worse, too much tax) years in advance for no reason. "You are triggering tax but not putting cash in your hand, so you need to look at the opportunity cost," says Deloitte's Stretch.

Say you're given $10,000 worth of restricted stock. If you're in the 35% bracket and make the 83(b) election, you'd pay $3,500 now. If the stock rises to $15,000 and you sell when you vest, you'd pay an additional $750 at today's 15% cap-gains rate, for a total of $4,250. (If the cap-gains rate goes to 20%, you'd pay $250 more.) If you didn't make the 83(b) election and paid income tax on the full $15,000, you'd owe $5,250. If you're in the highest marginal rate and it goes to 39.6% by the time your restricted stock vests, you'd owe $5,940. That potentially higher tax hit, plus the likelihood that stock you'd receive has been pummeled in the market rout, is why Barbetti recommends considering the 83(b) election now. "If you think your restricted stock will vest in a higher tax year," he says, "then maybe you bite the bullet and pay the tax this year."

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