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:
- If you expect to need cash from your taxable investments within the next 1-2 years, and your income before the likely capital gains would exceed $250,000 for married couples ($200,000 for individuals) [this is the Medicare Surcharge Threshold – see below for definition], you should strongly consider realizing the gains this year and perhaps reinvesting the proceeds until you need the cash.
- If your income probably would not exceed the Medicare Surcharge Threshold, uncertainty about future tax rates and future investment returns, as well as the variations in local tax rates make this a situation where there is no single correct answer. In addition, the answer depends upon when you would be selling your holdings to spend the proceeds.
- If you expect to need cash from your taxable investments within the next 1-2 years, and you believe that capital gains tax rates are very likely to rise, you should strongly consider realizing the gains this year and perhaps reinvesting the proceeds until you need the cash.
- If you are a “long-term investor,” and you don’t expect to need to realize gains for a while (say 5 years or more), you probably shouldn’t realize gains this year in order to “pay lower taxes now” – the benefits of tax deferral are likely to be greater than your potential savings.
- If you are an active investor, and realize capital gains frequently anyway, it won’t hurt much to realize gains now – you probably get little benefit from tax deferral anyway, and there is a chance you’ll save on taxes.
- If neither of the first two bullets applies, more analysis is required. You should more strongly consider realizing capital gains this year if you are confident that:
- Capital gains tax rates will rise; and / or
- You will have high income (over the MST); and / or
- You are likely to need cash from your portfolio sooner rather than later; and / or
- You live in a state or location with currently low tax rates on capital gains (e.g., New Hampshire, not New York City).
- I do not recommend realizing gains on bond mutual funds unless you are likely to need the funds in two years or less.
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.
- Bush tax cut reversion – if the so-called Bush tax cuts expire, the Federal income tax on long term capital gains would increase from 15% to 18% for securities held longer than five years, and to 20% for securities held longer than one year and less than five years. Many proposed fiscal cliff solutions involve increases in capital gains tax rates, but most are in this range, which would also apply if the Congress takes no action. However, there is no certainty that capital gains tax rates will increase.
- Medicare Investment Income Tax Surcharge – as part of the Affordable Care Act, the Federal income tax on investment income, including capital gains, will increase by 3.8% for investment income which increases your total income over $250,000 for married couples ($200,000 for individuals)[I will call this the Medicare Surcharge Threshold or MST]. I’m not aware of any serious proposals that would eliminate this tax rate increase.
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:
- Return to pre-Bush taxes on medium term gains (1-5 years) [5% increase] is larger than pre-Bush taxes on ultra-long gains (more than 5 years) [3% increase]; there may be no increase here.
- Larger if you are subject to the Medicare Surcharge than if not [3.8% vs. 0%].
The tax deferral benefit will be larger:
- The higher capital gains turn out to be from now until you really need the assets to spend (this would give you more return on the taxes you don’t pay);
- The higher your current tax rate on capital gains (if you live in a location with a high capital gains tax (such as New York City) the taxes you don’t pay now would be larger);
- The longer you can wait until you need the assets (more years of returns on the taxes you don’t pay).
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:
- If you sold the bond funds expecting their prices to fall, you would probably hold mostly cash with the proceeds.
- Bonds are paying more interest than cash.
- 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.
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.