Wise strategies are not always clear when managing finances. In some cases, it’s even the counterintuitive option that is most valuable.
The remainder of 2012 offers one of these unnatural-but-wise planning opportunities. Ultimately, this strategy can reduce tax costs, effectively increase your after-tax investment returns and help reduce risk in your portfolio.
Often, investors prefer to postpone the realization of capital gains so that the associated tax bill is put off into the future. When considering transactions in taxable investment accounts, the focus is more frequently on realizing, or harvesting, losses to use against capital gains and possibly to offset some ordinary income. Most investors are more comfortable moving away from a loser and re-investing in something else than they are selling a winner.
But here’s why taxable investment decisions are being turned on their head in some cases.
In 2013, the capital gains tax is scheduled to rise from 15 percent to 20 percent of the gain. This is a 33 percent increase in the tax bill. For example, if you sell an investment and realize a gain of $10,000, you will have a $1,500 tax cost in 2012 but a $2,000 tax bill in 2013 and likely well beyond. The change in capital gains taxes will be even more impactful for both low income earners and high income earners.
If you are in the 15 percent marginal income tax bracket, you currently have zero capital gains tax liability. But next year, the capital gains tax is scheduled to go up to 10 percent in the lowest tax brackets. This will particularly affect retirees without much taxable income but who have long-held investments with significant gains.
For individual taxpayers with adjusted gross income over $200,000 (or $250,000 if married and filing jointly), an additional 3.8 percent tax to support Medicare will be added to capital gains after Jan. 1, 2013. This would effectively increase the capital gains tax by 59 percent – from 15 percent today to 23.8 percent.
Given this circumstance, it will be advantageous in many cases to sell positions with capital gains this year so that those gains are taxed at a lower rate.
MORE REASONS TO SELL NOW
If you have a significant capital gain in a single holding, it may represent a concentrated position. By selling it you can use the proceeds to diversify your portfolio, reducing the risk inherent in large positions in a single investment.
Even if you still like the investment and want to keep it as part of your mix, you can simply buy it back.
There is no wash-sale rule on positions with gains to restrict your ability to immediately repurchase the investment. This way, you pay the capital gains tax at a lower rate as part of your 2012 return and you reset the cost basis to a higher level so that the next time the position is sold, less gain is exposed to the higher capital gains tax rate.
REASONS NOT TO HARVEST GAINS
If you have a capital-loss carryforward from losses realized in previous years – many people still carry substantial losses from selling during previous bear markets – it’s best to wait. The capital-loss carryforward is used to offset realized capital gains. Rather than using previous losses to offset gains when the capital gains rate is 15 percent, it would be a more valuable use of the capital-loss carryforward to use it in the future to offset capital gains at the 20 percent rate.
If you expect to hold a position until your death, capital gains taxes shouldn’t be a consideration. The holding will receive a step up in cost basis to your date-of-death value. Your heirs will inherit a position with little or no capital gain, regardless of the amount of gain that accumulated over your holding period.
Charitable giving presents an excellent option for people who desire to be tax efficient and support causes or organizations they admire at the same time. You can gift a holding with a capital gain to a qualified nonprofit and neither the organization nor you will owe any capital gains tax. Instead, you receive a tax deduction – a clear win-win situation. In most cases, it’s a much better option than using your liquid cash to make donations.
Preferably, you have enough cash in a non-investment account to cover the amount of the capital gains tax. If you do not and you would have to use some of the proceeds from the sale of the investment to pay the tax, you’ll have fewer dollars to reinvest and continue to grow.
As with all opportunities involving taxation and investments, it’s wise to confirm the actual effect on your money before acting. Your financial adviser and/or accountant can help you weigh the costs vs. the benefits for your personal situation.Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Old Town Tacoma. Reach him at email@example.com.