Sensible Perspectives

It’s (Almost) 2013, Do You Know What Your (Capital Gains) Taxes Will Be?

Posted by on December 14, 2012

Along with the “Fiscal Cliff” (which I wrote about very recently) come two potential capital gains tax increases, of different sizes, and with different degrees of uncertainty. Given that we have at least some warning, is there anything you can do to minimize their impact on you? The short answer follows immediately:

Some supporting detail follows. However, this is an extraordinarily complex decision, with relatively small stakes. If you think that you might benefit from realizing gains this year, please get in touch with me so that I can help you consider your situation more carefully.

We begin by looking at the potential changes.

Capital gains taxes: Bush tax cut expiration and Medicare Surcharge from the Affordable Care Act.

Since capital gains taxes are almost certainly going up for people with incomes above the MST, and may be going up for everyone, it seems to make sense to realize gains this year, before taxes increase. However, it’s important to recognize that paying income taxes this year means that you will forego potential capital gain and dividend income on those taxes (the benefit of tax deferral). So, you are trading off savings on future taxes (the benefit of paying now at lower rates) against foregone tax deferral benefits (the benefit of keeping the taxes you might pay now invested and earning returns).

The future taxes you might save by paying now will be larger if the tax increase that actually occurs is larger:

The tax deferral benefit will be larger:

So, how does this all play out? Unfortunately, it depends!

I have analyzed the various combinations of factors in detail, and I’ve written up the analysis. My colleagues wouldn’t let me send it – much too complicated!

So – in the rest of this letter, I provide a summary. If you can decide what to do based on the summary, excellent! If you can’t decide, call me or send me an email, and I can do some analysis for you pretty quickly. However, it is important to remember that if your capital gains are a relatively small proportion of your portfolio, the impact of perfectly minimizing your taxes around this issue will have a minimal impact on your investment return and on your ability to accomplish your plan.

We start by looking at the maximum advantage of selling this year versus waiting until next year – think of this as the advantage of selling December 31 of this year as opposed to January 1 of next year. This maximum advantage doesn’t depend on the capital gains tax rate where you live – it’s just the difference in tax rates. Thus, for the Medicare Surtax only, the advantage is 3.8% of your capital gains, for medium (1-5 years) and long (over 5 years) term gains under the pre-Bush rates, the maximum differences are 3% and 5% respectively. Finally, for the Medicare Surtax and the pre-Bush rates together, the maximum differences are 6.8% and 8.8% respectively.

I want to emphasize that each advantage is a percentage of your gains, not a percentage of your portfolio. For example, suppose you have a $55,000 holding including a 10% or $5,000 gain. Then your maximum potential saving is 8.8% of the gain, or $440. That’s less than 1% of your holding.

Each advantage diminishes as the number of years until you need the money grows.

If you know you need the money now, or next year, and your income exceeds the MST, then the tax saving is easy to obtain, and certain. It makes sense to raise the cash now.

If you might need money in 5 years, and your income doesn’t exceed the MST, then the potential saving is uncertain, and likely to be small. It’s probably not worth the trouble to sell your holding now and reinvest it, paying taxes you don’t have to pay now in the hope of achieving a small saving at some point down the road.

The Special Case of Bonds

Bond interest rates are at historic lows. It is not unlikely that they will rise in the next few years, and the prices of bond funds will fall. This will naturally reduce the size of any bond fund capital gains you have now, and may reduce them to zero. It would be very sad to sell the funds now, realize gains, pay taxes, and then to realize a few years later that just by waiting you could have paid lower capital gains taxes, or even no capital gains taxes. In addition, you’ll be missing out on interest income on the capital gains tax paid. Therefore, I do not recommend selling your bond funds with capital gains unless you will need the money soon (say, in the next two years).

You might ask, why not sell now and realize gains if the prices are going to go down? The answer is two-fold:

  1. If you sold the bond funds expecting their prices to fall, you would probably hold mostly cash with the proceeds.
  2. Bonds are paying more interest than cash.
  3. We don’t know when bond prices will fall, nor do we know for how long, or how far. Mistiming the fund sale and eventual repurchase could easily cost a great deal more than simply holding on, receiving interest, and having your index bond funds gradually reinvest maturing principal in newly issued bonds with higher interest rates.

Summary

There is a good deal of uncertainty about future capital gains tax rates and future capital gains returns.

This makes it difficult to analyze the tradeoff between (potential) tax savings from realizing gains now and potential after-tax return benefits of tax deferral.

If you have high income (above the MST) or if you have income below the MST and believe strongly that capital gains tax rates will rise, and if you will need money from your portfolio in the next 2 years, it is probably to your advantage to raise the cash now, reinvesting it if you don’t need the money next year.

If you rarely realize capital gains and you don’t expect to need money from your portfolio in the next five years, it is probably not to your advantage to realize gains now.