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Fleece The Golden Geese

“Like the Inflationary 1970’s, Investors Will be Expected to Bail out Washington’s Financial Mess”

The old saying “not what you make, but what you keep” really holds true with investing and taxes.

Taxes strongly influence investment choices, when profits and losses are realized, and which types of brokerage accounts are used (taxable versus tax-deferred).

Historically, tax rates ebbed and flowed, and the government has developed a complicated maze of investment-related taxes such as income tax, capital gains, estate taxes, and penalties for early and late IRA withdrawals, just to name a few.

Income taxes were permanently imposed on US citizens in 1913 and have increased and reduced on twenty-two separate occasions. Top income tax rates have ranged from 15% in 1916 to 94% in 1944. Capital gains tax has ranged from 7% in 1913 to 40% in 1975. As expected, the big jump in tax rates in 1917, 1932/34 and 1975 were not well received on Wall Street as the stock market lagged badly in the following years.

Over time, much has been written about taxes on investments, and though these articles and books have been written in different eras about different situations, they all deal with the need for an individual’s investment strategy to strike a balance between realizing maximum profits and minimizing the impact of taxes.

Simply put, selling an investment at a high point is always an investor’s goal, and yet in the world of taxes, it might not be the most profitable solution. With inflation raging and both federal & state governments conjuring up creative ways to squeeze more money from your portfolio, investor’s will need to take steps to protect wealth:

Rebalance into Commodities & Learn to “Buy & Hedge” –

There is a strong inverse relationship between the level of the capital gains tax rate and the direction of the stock market. As can be seen in the chart below, during the two periods ranging from eight to ten years in which the tax exceeded 30%, the stock market severely underperformed “tax friendly” bull markets.

During the high tax, inflationary 1970’s, the stock market traded sideways while commodities (ranging from crude to corn) posted one of its best bull markets ever. Investors who had commodity-oriented investments in their portfolios, used options or short selling to hedge stocks during downtrends and owned real estate in growing markets came out ahead.

Watch out for Investment Tax Land Mines –

It is important to remember that though the level of tax rates has been in general decline since the late 1940’s, investment tax law has become very complicated and biased. It’s easily made a good investment strategy into a taxable nightmare.

The three most glaring examples are:

1.      Dividends paid to stockholders are taxed twice (first on corporate profits before investors are paid).

2.      Tax-free municipal bonds are subject to alternative minimum tax AMT penalties imposed on high net-worth earners.

3.      Investors with investment losses are allowed a pitiful $3,000 per year write-off against income if there are no investment gains (now or in the future) to offset. In other words, the annual investment income & gains are shared with Uncle Sam, but investment losses are the sole burden of the investor.

17th Century French politician Jean-Baptiste Colbert once said, “The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest amount of hissing.”

As the U.S. faces a debt crisis with geopolitical & social consequences, it appears the investors (big & small) will once again be Washington’s plucked Golden Geese with a slate of new taxes in the future.

Sadly, history does repeat itself. During the last two inflationary periods, investment related taxes were significantly raised. The last time the capital gains tax rate increased to 40% (1975), stocks, bonds and real estate investors had the tax & inflation “double hit” that retarded U.S. asset appreciation for many years.

Through bad fiscal & monetary policies, the government leaves its fingerprints on most economic disasters. The end of the great stock & real estate bull market is in sight!

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