How an upcoming tax bill could impact your portfolio

Wednesday: The Independent Investor FROM THE DESK OF MILES EVERSON: Taxes impact investing. The higher the taxes, the lower the economic activity. This is because higher taxes increase the cost of action and lessen the number of people who want to perform that action. If you’re an independent investor who’s looking to grow your investments, you must have a full understanding of how an upcoming tax bill could impact your portfolio. The more informed you are, the wiser you’ll be in the next decisions you will make. Continue reading below to know more about the effects of taxes on investments and how you can still boost your portfolio despite changes in the finance environment. CEO, MBO Partners Chairman of the Advisory Board, The I Institute

How an upcoming tax bill could impact your portfolio Higher taxes raise the cost of the action and reduce the number of people who want to perform it. In other words, if you increase taxes, you decrease economic activity. So, a government that wants to decrease investing activity can simply raise taxes on investments. Say taxes on capital gains double from 25% to 50%. Imagine the impact of this increase on $1 of dividends for a stock that trades at $40 a share. When you think about how much you’re paying when you buy an item, you think in terms of net pay, not gross pay. The same goes for investing. You want to know what your after-tax return is, not what you get before Uncle Sam takes his cut. Going back to our example, if dividend taxes rise from 25% to 50%, $1 of dividends that used to yield $0.75 in income now earns only $0.50. The after-tax earnings effectively fell by a third. For investors valuing how much the stock is worth, this changes their thinking. Now, they’ll only be willing to pay two-thirds of the prior price, meaning the $40 stock would only be worth $27. This is why if taxes go up, it’s likely to be a headwind for the market. It won’t be as dramatic as in the example I just discussed. We’re not actually looking at capital gains and dividend taxes jumping from 25% to 50%. At worst, we’re talking about investment taxes rising from current 20% levels up to 29%. This increase would certainly hurt the market as a one-time reset, but it wouldn’t be enough to cause the broad market to fall 33%. Using the same math, it means the market would be worth 11% less after the tax hike than before. Like inflation, higher taxes mean higher discount rates―the rate investors use to translate a dollar of “future” money into today’s value. That’s why in a high tax environment, even when inflation is muted between 0% and 4%, investors are looking at a 16 times average P/E ratio, rather than 20 times when taxes are low. Let’s take a look at the historical data… One important piece of advice, as any good financial advisor will tell you: Just because taxes might go up soon doesn’t mean you should change your investment strategy. Wait until you actually see the data, because the real tax plan that makes it through a divided Congress may be much different from what the headlines suggest. Here’s another big takeaway: Beware of rising capital gains and dividend taxes, but don’t overreact to them. Little risk of mass defaults and strong corporate profitability support high market valuations. This means bailing out of the market now could leave further gains on the table. Let the market “noise” clear and continue to take advantage of opportunities to buy the dip… and of course, if anything changes to upend the tax environment, we will let you know immediately. Hope you’ve found this week’s insights interesting and helpful. Follow us on LinkedIn. Stay tuned for next week’s 12 Days of Christmas BBD Campaign! What activity would you like to do most during Christmas? Learn more about how one restaurant chain fulfilled its customers’ ultimate Christmas wishes on next week’s The Independent Investor!