I’m pleased to bring you another edition of Cumberland Advisors Market Commentary by David R. Kotok. For newcomers and regular readers alike, please head over to Cumberland’s Introduction and Biographies page which can be found here. To sign up for their free newsletter yourself, please point your browser at: http://www.cumber.com/signup.aspx. Now, let’s get right in to this edition:
We have a little technical correction on our recent piece (July 22) about taxes and dividends and capital gains. See: www.cumber.com.
This year the long-term cap gains federal tax rate is 15%. The debate over what the cap gains tax will be is unlikely to be resolved until after the November election. Geithner has said the Obama administration will seek a rate of 20%.
Many other influences determine the net cap gain a taxpayer can pay. Here is one example.
Suppose a taxpayer in NJ has a very large cap gain and plans to take it this year because he thinks it will be taxed at 15% federally. NJ will tax it at 9%, just like other income, because NJ does not recognize long-term cap gain treatment. The taxpayer may be able to deduct the 9% against federal income, so the net impact may be about 6% after the deduction. However, the high NJ state income tax could trigger the federal Alternative Minimum Tax (AMT). Then the deduction will not apply and the taxpayer could find himself in a 28% AMT bracket with no deduction for the NJ tax. The taking of the cap gain could use up some or all of the AMT exclusion and actually help trigger this unfortunate AMT effect.
Look at what has happened to this taxpayer who thought he was going to take a long-term gain this year at 15%. Instead, he paid 9% to NJ and received no federal deduction. In addition, he lost his other deductions that are federal preference items. Moreover, his net federal tax rate became 28%. However, we must also remember that this happened only because his overall tax rate at a top bracket of 35% produced a lower net tax to the federal government than under the AMT method of calculation.
As AMT taxpayers know, there are two ways to figure your income taxes. The government forces the taxpayer to choose the one that yields the most taxes to the government.
Under the very worst set of calculations, the 15% actually became an effective federal rate of 35% by crowding out other items and triggering the AMT. Moreover, the state rate of 9% is added to it. Therefore, the effective cap gain rate reached 44% instead of 15%.
As to dividends, we cited the work of the Tax Foundation as reported by Strategas. There was a technical error in the original Strategas report.
Strategas published a change to correct it, and we compliment them on their quick response. They wrote: “An astute client pointed out to us that a table in the Policy Outlook (7/14) and Weekend Reader (7/17) incorrectly noted the effective dividend tax rate will reach 67.6 pct in 2011. This calculation included the new Medicare tax on investment income, enacted as part of the recent healthcare bill, but that will not kick in until 2013. Under current law, the effective tax rate will increase from 49.6 pct this year to 63.8 pct for 2011 and 2012, and it increases to 67.6 pct in 2013 (assuming no action from Congress).”
Our friend Dean Eisen suggested that we clarify the high-income thresholds that apply to the Medicare tax. Dean is one of the sharpest-eyed observers we know. We put his question to Strategas.
Dan Clifton at Strategas answered:
To your question below: The high-income household definition is defined two ways.Generally, the higher income taxpayer is defined as the top two tax rates. Currently the 33 pct tax rate applies to singles making $171,850 to $373,650 and couples making $209,250 to $373,650. Above those levels, the top tax rate kicks at 35 pct.On January 1, those tax rates increase. The 33 pct rate increases to 36 pct and the 35 pct rate increases to 39.6 pct.As you know, President Obama proposed raising taxes to individuals making $200k and couples making $250k. If he was to achieve this proposal then the 36 pct tax rate would not kick in at $171,850/$209,250 but rather at $200,000/$250,000 (single/couple).The current Administration proposal is to have a 20/20 capital gains and dividend income tax rate. But if the tax cuts expire, the capital gains tax rate goes to 20 pct and the dividend tax rate goes to ordinary income with the highest tax rate at 39.6 pct.
Many thanks go to Dan Clifton, Dean Eisen, and Meghan Wennersten for their technical help. All errors are mine.
Taxes are very complex. Readers are advised to consult their personal tax advisers for any calculations or issues regarding dividends, cap gains, or anything else involving their taxes.
David Kotok, Chairman and Chief Investment Officer
