Paying a voluntary tax is always uncomfortable. It is far easier to postpone paying taxes until some date in the future. Between now and year end, however, we must consider the pros and cons of moves that deliberately raise our 2012 tax bill. We encourage you to call us to discuss moves that might make sense for you.
Accelerate Capital Gains in 2012?
This communication discusses the issue of recognizing long term capital gains. For many years the tax on profit from investment assets held for a year or longer has been subject to a maximum federal tax rate of 15%. Beginning in 2013, for married couples with taxable income of $250,000 or above ($200,000 for singles) realized long term capital gains, to the extent they exceed the limits above, will incur an additional 3.8% surtax. In addition, if the fiscal cliff rates take effect or if President Obama’s proposal is accepted, the long term capital gains tax rate will rise to 20% from the current 15%.
If you fall into the affected group, your first reaction may be to sell all holdings with long term capital gains now and the buy them back immediately. You would then hold the same portfolio but you will have reset (raised) the basis of your assets. You would create a larger tax bill for 2012 but the profits would be taxed at 15%, not at 18.8% or 23.8% – a savings indeed. Don’t forget that when you recognize capital gains you also must pay any applicable state and local income taxes as well.
Problems with “Gain Harvesting”
For low turnover portfolios it doesn’t work. You will deplete your holdings by the amount of the additional taxes due, ending with fewer shares. So a smaller pool will be available for future growth. For most of us, the longer you keep the money from the government, the more wealth you build.
- You will pay tax all at once rather than spreading the liability over your lifetime. Most folks sell investments when they need to use the proceeds – a process that occurs slowly over time, distributing the tax bill over multiple future years. Yes, the tax rate after 2012 is higher but more money is working, capital-gains-tax-deferred.
- The market is volatile. It is impossible to know the optimal time to make the sales. Ideally, you want to choose a day when prices are down in order to minimize your gain and to repurchase at a lower price. But no one can predict market swings.
- It is almost assured that tax schemes and rates will continue to change over your lifetime, perhaps creating lower capital gains taxes or eliminating them in the future.
Factors to Consider
Charitable commitments: If you intend to make charitable contributions with long-term capital gain property in the coming years, you have less exposure to higher tax rates. Don’t sell assets you intend to donate.
Loss Carry Forward: What remains of your loss carry-forward? Whether you sell this year or next is immaterial if your unrealized gains are fewer than your carry-forward.
Your age: The current tax code allows heirs to “step-up” the cost basis of inherited investments to the fair market value on the date of death. There’s no guarantee that this provision will survive a tax overhaul. However, for investors who are older or in poor health, harvesting gains now may eliminate the advantage of a step up in basis.
How long you plan to hold an asset: A core holding that you will retain indefinitely is probably not a good candidate for immediate sale. Your time horizon is a major driver of your decision.
Your future tax bracket:If you will earn less in coming years or at retirement, you may escape the income tax brackets subject to these higher rates.
Actions to Consider:
- Taking capital gains this year if you have a committed future outlay that will require raising cash in the near term. For example, if you will fund college expenses or remodel your home, selling assets this year is attractive.
- Selling an asset that you hold at a gain and that is not a good long term choice. We can review with you assets held outside of portfolios we manage.
- Rebalancing taxable portfolios before year end, recognizing gains at today’s lower rate.
At Capelli Financial Services, Inc., we will be rebalancing portfolios as appropriate before year end. And for clients subject to the higher taxes going forward, we will be reviewing whether taking additional action makes sense.
Please call us to discuss your personal situation.
We all want to minimize our tax bill. While tax strategies are important and always a consideration, they are not the primary driver of investment decisions. Sound investment strategies depend on a coordinated analysis of your goals and needs, overall position, resources, tolerance for risk, view of markets and other factors.