Potential Tax Changes Looming

There is so much uncertainty revolving around the estate tax and taxes on capital gains and dividends lately I thought it would be helpful to go over what is happening so far. Unfortunately, about the only sure thing I can see now is that it looks like nothing will be decided until after the elections, when republicans hope to have a better chance of extending the Bush tax cuts and passing a reasonable estate tax revision.

The two proposals for estate tax revisions so far are as follows:

- Set the estate tax rate at 35% permanently and slowly increase the exemption from $3.5 million up to $5 million.

- Use the bill passed by the House late last year which would set the rate at 45% permanently with an exemption of $3.5 million.

A third possibility would be some compromise between the two which would most likely revolve around the number of years for the new policy to be phased in and staggered rates to be applied to different size estates. On either side there is a lot at stake. If the Republicans wait until after the elections to strike, that doesn't leave them with much time to get it accomplished before the end of the year. If the Democrats want to get something accomplished before the elections, they are going to need to make some compromises or it won't happen. If nothing gets done, then it falls back to 55% tax on estates over $1 million. This is not very likely as it will really upset the constituents on both sides and will damage the already fledging confidence in our current representatives.

Beyond the estate tax there is the looming expiration of the Bush-era tax cuts. The tax cuts included marginal tax rates as well as dividend and capital gains taxes. If they expire, the capital gains rate would go up from 15% to 20% and dividends could potentially be taxed at up to 39.6%. There are several issues that will most likely keep this from happening. The first is that if dividends and capital gains are not tied together, then dividend paying companies will simply lower or stop paying their dividends. This would cause a major reduction in the income of millions of seniors that depend on their dividends for their livelihood. Other investors would stay away from dividend paying companies and invest in growth stocks instead. Another major roadblock to letting these tax cuts expire is the extremely fragile nature of our economic recovery. Letting these tax cuts expire would be a severe blow to the recovery and with our current employment problems and lack of leverage, it should be obvious to all that this is not a good time to let this happen. Although I am not confident that this will be resolved this year, there is a very good chance that the tax cuts will be extended for at least another year.

As for the marginal tax rates, there is a lot that needs to be revised if Obama wants to keep his promise that it won't affect families making less than $250,000 (or $200,000 for individuals). Obama has asked congress to extend the tax rates for everyone making less than $250,000, and to only raise the taxes for those that are in the highest tax bracket. For those tax payers in the 35% bracket, it looks like it will go up to 36% and potentially up to 39.6% for the highest income earners.

All this being said, I want to stress that absolutely nothing has been decided yet. Most politicians are reluctant to raise taxes given our current economy and the fact that this is an election year. Most of this will probably be put off until closer to or after the elections.

Michael Vandenburg, CFP®

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