Selling Now to Avoid Higher Taxes Later?

Income taxes are going to increase. That’s the message coming from Washington. We don’t know which taxes will increase or by how much, but there seems to be strong majority support for higher taxes. Rising federal spending also makes higher taxes more likely.

At a minimum, it appears the 2003 tax cuts will expire at the end of 2010. That would move many people into a higher tax bracket and establish a top tax bracket of at least 39.6%. It also appears likely the long-term capital gains rate will rise to at least 20%, and the maximum rate on qualified dividends will as well. Some people think these rates will rise higher. Other people believe other taxes will be increased.

We already discussed why the prospect of higher future tax rates means deferring income and taxes may not be the best strategy going forward. (See the February 2009 issue.) Many people now are wondering if they should sell assets now or take other steps to avoid higher tax rates on capital gains in the next few years.

The issue is not as easy as it sounds. Here’s how to make a decision.

Higher tax rates aren’t likely until 2011. It’s possible the economic downturn will convince our leaders to defer the higher taxes beyond 2011. We should have a good idea of the details late in 2010. I think you shouldn’t rush to sell assets until we have a better idea of what the rules will be.  There’s too much uncertainty now to make a good decision.

When we do know more details about future tax rates, here’s how to decide which moves to make.

First, consider assets in qualified retirement plans, such as 401(k)s and IRAs. Distributions from the plans are taxed as ordinary income. You may be able to withdraw the assets now and pay taxes at today’s rates. Then, you can invest the after-tax amount in a taxable account. You could structure your investments in the taxable account so you are more likely to pay future taxes mostly at the long-term capital gains rate, which is likely to be lower than the ordinary income tax rate. By taking distributions early, you avoid higher ordinary income tax rates on the distributions, and you have future gains taxed at the lower capital gains rate instead of the ordinary income tax rate.

You should be able to estimate, perhaps with the help of your tax advisor, how much tax rates have to rise to make it profitable to give up tax deferral.

Of course, you also can convert a traditional IRA or other qualified retirement plan to a Roth IRA. We’ve discussed this a lot the last few visits, including earlier in this one. Review those discussions to decide if a conversion is for you.

Second, consider investments that already are in a taxable account. The best way to handle assets that have meaningful capital gains depends on more than a change in tax rates.

One factor is your age. Under current estate tax law, no one pays taxes on capital gains accrued during your lifetime when you still own the assets at your death. The person inheriting an asset increases its tax basis to the current market value. At that point the assets could be sold immediately for no taxable capital gain. We should know sometime during 2010 if that rule will stay intact. If it stays, the older you are the less profitable it may be to sell assets to avoid a future capital gains tax hike. You could hold them and avoid any taxes on the gains. You would want to consider the sale only of assets you are likely to sell anyway in the next few years.

Investors with a longer-term horizon might choose to take some gains when a higher capital gains rate seems likely.

A rise in the long-term capital gains tax rate from 15% to 20% means you will pay $5 of additional taxes for each $100 of gains. Remember the $5 additional tax is on the gains, not the current value of the investment.

When you were seriously considering a sale of an asset in the next year or two, there doesn’t seem to be a lot to consider. Accelerating the sale to 2010 saves money on a move you were going to make anyway.

But take a deeper look.

Consider first the potential appreciation left in the asset. Then, consider the taxes you would save by selling now and also the return on whatever asset you would invest in after the sale.

When your money will earn the same rate of return after the sale, there isn’t much of an issue. You’ll be better off paying the taxes now at the lower rate and moving the after-tax proceeds to another investment.

The decision may be different when the new investment would earn a lower rate of return.

Suppose you would invest in something else that earns a lower rate of return. At some point it makes sense to pay taxes later at the higher capital gains rate if the current asset has a higher rate of return than any new investment would.

How much more would the current asset have to appreciate to justify holding it and paying the higher taxes in a year or two?

When capital gains taxes increase from 15% to 20%, that is a one third increase. A simple rule is the current investment needs an annual return more than one third higher than the new investment’s return to justify holding the investment and paying higher tax rates later.

For example, suppose you have a $10,000 asset with an $8,000 basis, for a $2,000 gain. You anticipate earning 6% on this investment.

Sell at the start of 2010, and you’ll have $9,700 after taxes. After earning 6%, you’ll have $10,282 at the end of 2010 and $10,899 aftertax at the end of 2011. On the other hand, don’t sell and you’ll have $10,600 pretax at the end of 2010. Sell at the end of 2011 and you’ll have $10,589 after paying taxes. That’s less than if you’d sold in 2010 and reinvested to earn the same rate of return. It makes sense to sell and pay the lower tax rate early.

Holding the investment and paying the higher tax rates in 2011, makes sense only if you the return on the current investment climbed to about 7.98% while you would earn only 6% after selling in 2010 and reinvesting.

Suppose if you sold in 2010 you would reinvest to earn 4%, compared with a 6% return if you didn’t sell. You’d have more money by selling later and paying taxes at the higher rate. Keeping the investment and paying higher future taxes would make sense if the return on the current investment fell as low as 5.5% in that case.

You can reinvest immediately in the same asset after selling at a gain. The “wash sale” rules apply only when you are trying to deduct investment losses. When you have a gain you don’t need to wait more than 30 days to repurchase the same or a substantially identical investment.

There are a couple of other points to keep in mind.

Some investors have a lot of loss carryforwards from losses in 2007 and 2008. They shouldn’t sell in 2010 to avoid a higher future capital gains rate. Their carryforward losses will shield the gains whenever they decide to sell.

Also, remember the lower long-term capital gains rate applies only when an asset is held more than one year. Sell even one day early and you pay the ordinary income tax rate.

After-tax returns are an important consideration in your investment planning. But don’t let the fear of tax hikes dictate your decisions. Make sure you consider any costs incurred from buying and selling investments compared to the potential tax savings. Consider all the angles before make a tax-motivated decision.

January 2010. RW