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Do Higher Taxes Mean It’s Time to Take Profits?

By Roger Conrad on December 14, 2012

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With less than two weeks left in 2012, Washington still doesn’t have a deal on the budget. But one thing is certain: Taxes on capital gains taken in 2013 aren’t going to be any lower than they are now.

That’s led a number of investors to conclude it’s time to take a profit on some big winners. And the results have shown up in many dividend-paying sectors.

Since the market bottomed in March 2009, master limited partnerships (MLP) have been among the market’s biggest winners. The Alerian MLP Index currently trades more than 130 percent above its bear market low on March 6, 2009. And many of its constituents have done far better.

For example, Magellan Midstream Partners LP (NYSE: MMP)–a longtime recommendation in our MLP Profits advisory–is up 226 percent since the bottom, not including dividends. And Enterprise Products Partners LP (NYSE: EPD) now sells for three times its bear market low.

Both Magellan and Enterprise, however, have been hit by selling in the fourth quarter of 2012, despite posting generally solid results and guidance. So has the Alerian MLP Index, which is down about 10 percent from early October and is now backing off levels reached in a late November rally.

Some of this selling may be due to fear that any deal that averts the so-called fiscal cliff will include new taxes on MLPs. But at this point, there’s been no movement on that issue in Congress. MLPs have powerful advocates in Washington, and they’ve apparently successfully argued that the expected gain of about $300 million from full taxation would be far offset by the economic cost of reduced investment in energy infrastructure.

And barring a last-minute change in their tax status, MLPs’ ability to pass on cash to investors as tax-deferred return of capital will be even more valuable come January 1. That’s in part because of higher tax rates on ordinary dividends. But it’s also because Congress and the White House are debating taxing the interest paid on municipal bonds, at least for high-bracket investors.

However, there is one reason why selling MLPs before the year ends could make sense for some investors: They can book capital gains earned from MLPs’ outperformance before the tax rate goes up.

For long-term investors, those gains are even larger when added to distributions that have deferred-tax liability because they were considered a return of capital. In fact, it’s likely many investors who bought MLPs at or near the bottom in early 2009 now have cost bases fairly close to zero.

Selling does mean taking a hit this year. But again, for any investor with selling on the agenda, it may make sense to make the move now at the lower rate and wipe out the future liability.

At this point, the Alerian MLP Index is still showing a total return of slightly less than 3 percent for the year. In terms of price, however, it’s underwater by a roughly equal amount. And if more people do elect to sell by year end to lock in capital gains, it could drift a bit lower.

That same desire is also likely playing a role in the underperformance of utility stocks during what’s normally a seasonally strong period. The Dow Jones Utility Average has produced positive returns in the fourth quarter 36 times since 1969. The only exceptions have been notable years, such as 2001, when Enron suddenly imploded and threatened the solvency of more than two-dozen companies. Utilities also lost money in the fourth quarter of 2008, though their losses were roughly half those of the S&P 500.

Like all dividend-paying stocks, utilities’ popularity could be hurt by higher tax rates. But so would US telecommunications companies, and the index for that sector is up 21 percent this year. The Bloomberg US REIT Index, meanwhile, is up 15 percent, despite the fact that dividends paid in that sector are likely to be hit by higher marginal tax rates.

The likely reason: Gains in telecom and REITs have been tough to come by in recent years. Consequently, there are few capital gains to take, so they haven’t really been targets for profit-taking.

Sell or Hold?

Should the rest of us take capital gains now? That depends on two things. First, consider whether the likely bump in the top capital gains rate to 23.8 percent from the current 15 percent makes enough of a difference to take the immediate hit. The 23.8 percent is basically a return to the Clinton-era rate of 20 percent, but also includes the new 3.8 percent Medicare tax on investment income that kicks in starting January 1.

The answer is not as clearcut as one might think. First, the Medicare tax only applies to single filers with incomes over $200,000 or married couples who make more than $250,000. Moreover, while the terms of a deal on the federal budget are highly uncertain, there’s a chance the base rate on capital gains and dividends won’t change for anyone earning less than those thresholds.

If you’re a member of a family that owns a corporation, taking all the income you can this year and paying today’s rates may indeed make sense. And as I’ve pointed out previously, that’s the primary reason we’ve seen companies pay early dividends, as well as special dividends that essentially return capital to major investors.

If you’re anyone else, it’s time to take a hard look at just what your new tax rates are likely to be next year–and weigh that against the hit you’ll take by selling a long-held position now.

One possibility is to minimize the tax hit by matching it against losses in other stocks. Barring a last minute market crash, for example, the model portfolios for my advisories Australian Edge, Canadian Edge, MLP Profits, Personal Finance and Utility Forecaster will finish 2012 comfortably in the black.

All these advisories, however, also have losing positions, some more than others. In fact, there are a few positions where selling momentum turned a retreat into a full-scale rout.

In past years, I’ve used December tax-selling season to clear out my walking dead in December, even stocks that I later planned to repurchase. This year, I’ve been reluctant to do so, in part because I see selling momentum likely to reverse next year, but also because the tax benefit of their losses will be greater next year.

Those who want to take big gains off the table this year should similarly look to their losers as ways to shelter income. The most important question to ask about whether to follow this strategy, however, is do your stocks still have the ability to grow your wealth?

Even if dividends are taxed as ordinary income, dividend-paying stocks are still the income investor’s best and only option. Stocks certainly won’t be taxed at any rate that’s higher than other income investments. And realizing even a 5 percent yield on a bond requires taking on hefty interest rate and credit risk, with no hope of growth. That’s measured against literally dozens of stocks yielding that much or more and growing dividends regularly.

If you take a profit now in a stock that you like, you’re eventually going to have to buy it back at some point. And unless you do balance out your gains and losses effectively, you will have less capital to invest, and therefore a reduced base on which to earn income.

Don’t get me wrong. It often does make sense to sell a stock. And I fully intend to sell several stocks from our model portfolios in the coming year. But that decision should be based on the prognosis for the underlying company.

It also makes sense to periodically take partial profits on stocks in order to rebalance your portfolio. That also ensures that no stock becomes such a large position that it can take down your whole portfolio if something goes awry with it.

But again, it’s a company’s growth that ultimately determines your returns. Improving your tax efficiency to minimize your burdens and keep your capital working for you will improve those returns. But they won’t grow your wealth unless you focus on underlying businesses first.

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Stock Talk

  1. avatar
    Tony Campos Reply December 15, 2012 at 12:44 AM EDT

    Hi from Arizona

  2. avatar
    Tony Campos Reply December 15, 2012 at 12:43 AM EDT

    Hi Tony, Thought you might like to see this analysis of the tax planning situation by Roger Conrad. Very timely especially this year.
    Jack