Preparing for Tax Hikes

Though many details are still fuzzy, Obama's victory confirmed what many have predicted for a while: Taxes on the wealthy are set to rise. Here's how to avoid a big tax bill

By Ben Steverman

For investors, especially wealthier Americans, the victory of Barack Obama's Presidential campaign has raised the fear of higher taxes.

Many pundits had already predicted that, regardless of the election's outcome, taxes would be going up. The costs of two wars and other spending has ballooned the federal budget deficit just when the government faces rising entitlement costs from the retirement of the Baby Boom generation. Plus, a deepening recession hurts tax revenue at the same time the U.S. Treasury is in the process of spending hundreds of billions of dollars to bail out the U.S. financial sector. "It does seem a no-brainer to plan for taxes to be higher in the future," says Thomas Rogers of the Portland Financial Planning Group in Portland, Me.

Obama actually proposes tax cuts on middle- and lower-income Americans, but he also campaigned on higher taxes on the wealthy—generally defined as couples earning more than $250,000 per year. Income-tax rates could be affected, as well as estate taxes and tax rates on capital gains and stock dividends (BusinessWeek, 6/11/08).

Delays Are Possible

Many economists cringe at the idea that the government could raise taxes during a recession, but Washington experts say it has happened several times in the past, when recessions and falling revenue often inflate deficits. The best hope for tax-fearing investors may be that Obama and the Democratic-controlled Congress will delay tax increases.

Obama was asked at his first post-election press conference on Nov. 7 if he would proceed with his upper-income tax hikes. "I think the plan that we've put forward is the right one," Obama said. "But obviously over the next several weeks and months, we are going to be continuing to take a look at the data and see what's taking place in the economy as a whole." He didn't address a reporter's query about whether tax changes would take effect in 2009 or later.

If Obama still must work out tax details with Congress and the members of his economic team, it's hard for investors to know how to plan and protect against higher taxes. "Reacting to legislation that may or may not pass is a fool's game," says Bedda D'Angelo, president of Fiduciary Solutions, a financial planning firm in Durham, N.C. "Congress never does quite what you think it is going to do." David L. Blain, president and chief investment officer at private wealth manager D.L. Blain & Co. adds: "Once we know what the rules are, we can plan for them. The biggest concern is we don't know what the final result is going to be."

Watch the Tax Tail

How worried should investors be about the signs pointing to higher tax rates? Certainly taxes can have a big impact on portfolios. According to a Morningstar (MORN) analysis, from 1926 to 2007, stocks gave a 10.4% return annually before taxes, but only a 8.2% return after taxes. Bonds' 5.5% annual return in that time frame shrinks to 3.5% after taxes.

But the impact of taxes is not the same for everyone. D'Angelo notes many clients worry about taxes even though they're not in a high tax bracket and wouldn't be affected by Obama's proposals.

When asked about the possible new tax rules, one financial planner after another repeated the truism: "The tax tail should not wag the investment dog." In other words, don't let a worry about taxes lead you to make foolish investment decisions that could hurt your long-term returns. One example, says Marilyn Bergen of CMC Advisers in Portland, Ore., is when investors hold onto huge chunks of stock in one company, perhaps inherited from relatives or obtained while working at a corporation. Investors might not want to sell the stock quickly for fear of the tax consequences, but the result can be an overconcentration of their assets in one company—a big risk in today's rocky stock market. "That might be the most significant blunder that people make related to taxes," Bergen says.