Tax planning was turned on its head by the last couple of tax laws. Several key planning rules need revisions for those who want to maximize after-tax wealth.
One of the oldest tax planning rules is that it is better to defer a tax whenever possible. Paying taxes tomorrow is better than paying them today. For savvy tax planners, now that isn’t always the case. It can make sense to pay taxes early. Let’s take a look at this new paradigm.
The 2003 tax law reduced the tax rates on dividends and long-term capital gains to 15%, the lowest rates on those types of income in decades. The top individual tax rate is 35%. That makes for one of the largest gaps between the top individual rate and the rate on tax-favored dividends and long-term gains.
These days the price of deferral often is to convert capital gains into ordinary income. Income and gains are tax deferred when they are earned in annuities, IRAs, 401(k)s, and other tax deferred accounts. Distributions from those accounts are taxed as ordinary income. Because of the large gap between tax rates on these two types of income, deferral can be a disadvantage when it converts capital gains and dividends into ordinary income.
We’ve demonstrated that in past visits. There are circumstances when it makes sense to empty an IRA early instead of deferring taxes for as long as possible. (See the October 2003 issue.) We even questioned the value of 401(k)s and traditional IRAs under the new tax rates. (See the September 2004 issue.) Sometimes it is better to pay taxes on income or gains at today’s rates. Then, have all future appreciation and dividends taxed at the lower rates. You also control the timing of many tax payments by deciding when to sell investments.
The possibilities of tax rate changes add a new wrinkle to today’s planning.
President Bush wants the current tax rates made permanent. Others argue that higher rates for ordinary income, capital gains, or both are likely in light of the federal budget deficits and spending levels.
You effectively can control when some taxes are paid by deciding when to sell assets. Should you sell assets in anticipation of higher tax rates to pay taxes at today’s lower rates?
Suppose you think tax rates on long-term gains will rise in the future. Suppose also that you have highly appreciated assets, such as a business, real estate, stocks, or mutual funds. When does it make sense for you to pay taxes on all the past appreciation at today’s lower rates, reinvest the after-tax proceeds in similar investments, and pay tomorrow’s higher tax rates only on future gains?
Example: Max Profits has a stock he bought long ago. It is worth $300,000 and has a $50,000 basis. Max believes capital gains taxes are about to increase and wants to know under what circumstances it makes sense to sell and pay the taxes today. He would reinvest the after-tax proceeds in the same or a similar investment, which he expects to return 8% annually.
If the long-term capital gains rate rises to 20% and the rate of return is 8% annually, then it makes sense for Max to pay taxes the year before the tax increase takes effect and reinvest the after-tax amount in the same or a similar investment. But this is true only if Max plans to hold the investment for another four years or less. If Max plans to hold the investment longer, my computer model shows that the compounding of gains on today’s value offsets the higher future tax rate.
What if the tax rate rises above 20%? My calculations show that each one percentage point increase in the tax rate extends the profitable holding period by about one year. For example, if the capital gains rate rises to 25%, then it makes sense for Max to sell the year before the tax increase and reinvest if he plans to hold the investment for another eight years or less. For any longer holding period, he gets a higher after-tax amount by deferring the taxes until he sells the investment.
How does the expected rate of return affect the decision? The lower the expected rate of return, the more it makes sense to pay taxes early. If Max expects only a 6% annual return going forward, paying taxes now is more profitable if he anticipates holding the investment another six years or less. That adds two years to the holding period. On the other hand, if he expects a 10% annual return, paying taxes early is profitable if he intends to hold the investment only another three years or less.
Let’s combine several changes. Suppose Max expects only a 6% return and capital gains rates rising to 25%. In that case, paying taxes makes sense if Max intends to hold the new investment for almost 11 years. If Max expects a 25% capital gains rate and a 10% annual return, paying taxes now is a smart move if his anticipated holding period is six years or less.
Keep in mind that the 30-day waiting period of the wash sale rules does not apply to transactions on which there is a gain. You can sell a stock or mutual fund at a gain and immediately reinvest the sale proceeds in the same investment.
The lesson is that if you anticipate tax rates on long-term capital gains to rise in the next year, it can make sense to pay capital gains taxes early. But tax-deferred compounding still can be a powerful tool. If the increase in capital gains rates is not steep and you weren’t planning to sell within a few years anyway, you are better off letting the future returns continue to compound on the current value rather than on a lower after-tax value.
But if we have a 1986-style tax reform in which the long-term capital gains rate jumps to 28% or higher, it is more profitable to sell before the change takes effect. It will take 10 years or more for the tax-deferred compounding to offset the higher tax rate.