Proposed Tax Changes

by Robert Sheard
(TMF Sheard)

LEXINGTON, KY. (July 2, 1998) -- As you may know by now, Congress is reportedly going to send a bill to President Clinton that would roll back the capital gains holding period from the new 18-month threshold to the previous 12-month requirement. That is, to qualify for the 20% capital gains tax rate under the proposal, one would need to hold a stock a year and a day instead of 18 months and a day.

Political debate on the appropriateness of such a move aside, several readers have asked what the effect of this move will be on the Workshop screens. And at the risk of jinxing the plan, I'll be blunt: it would be a great change for our annual holding models in the Workshop. We would be getting the near-30% tax reduction on capital gains we should have received with the last tax revision, before last-minute screwing around with the tax code cheated us out of it. (Darn it, I said I wasn't going to talk politics!)

Back to the numbers. Let's say you're working with a pre-tax return of 26.7% (the historical compounded growth rate for the 10-stock Keystone model from January 1, 1986 through June 24, 1998). If you're updating your portfolio annually, under the current rules, your capital gains tax rate is limited to 28%. After taxes, then, your return is reduced to 19.22%.

If the rates are rolled back so that a one-year cycle is taxed at 20% instead of 28%, that after-tax rate becomes 21.36%. Same investments, same cycle, same ordinary tax bracket, but now we have an after-tax return of more than two percentage points higher.

Over the course of a couple of decades (assuming a constant growth rate), that differential can make a big difference to your investment account. For example, if you begin with $50,000 and earn an after-tax rate of 19.22% for thirty years, you end up with $9,759,859.

Now with the reduced tax rate, take the same starting amount and time period, but apply the higher after-tax return of 21.36% and your portfolio ends up with $16,643,208. Over thirty years, the rolled-back tax rate allows you to accumulate over 70% more on the same series of investments.

Now whether these before-tax returns are the right ones to base this calculation on isn't important. Choose any figure you want to run your own comparison, and you'll see a dramatic difference with the proposed tax changes.

Now all we can do is hope the pols don't mess around with this bill and screw up again what they should have done right last year. No mean feat inside the Beltway.

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[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]