The impending jump in capital gains taxes has prompted a flood of nervous calls to financial advisers in recent months.
Less than three months remain until the maximum rate of 15 percent on long-term gains rises to 20 percent unless Congress extends the Bush-era tax cuts.
On top of that, the health care reform package imposes a new 3.8 percent Medicare tax on the investment income of high-income earners. That means their tax bill will increase by more than half to 23.8 percent for single filers with incomes of more than $200,000 and couples who make over $250,000.
The looming increase poses a tempting reason to sell now for anyone who’s sitting on large unrealized gains in stocks, property or other assets. But pulling the trigger on a sale hastily could be a mistake.
A couple of Joe Heider’s clients were in “almost a Chicken Little mode” over the much steeper tax bills they could face, says the regional managing principal of Rehmann Financial Group in Cleveland. One, a corporate executive with stock holdings worth several million dollars, wanted to sell all his shares until Heider talked him out of it.
It’s not just millionaires with money at stake. Plenty of retirees who regularly sell off some of their portfolio for living expenses could face heftier bills on stocks, mutual funds or bonds that have grown appreciably in value over the years.
Those inclined to overreact by selling now without analyzing their situation would be wise to heed the old Wall Street adage: “Don’t let the tax tail wag the investment dog.” In other words, don’t become preoccupied with taxes at the expense of the ultimate objective.
“Keep in mind that first and foremost it’s about making a gain,” says Heider. “The key is making money.”
With that caveat in mind, here are five tips for approaching the possible capital gains tax hike:
Do some basic math, or have a financial adviser do it for you.
“If you’re selling just because rates are going up, think twice,” says Rande Spiegelman, vice president of financial planning in the Schwab Center for Financial Research. “I don’t see selling just to lock in a lower capital gains rate.”
Start by reviewing your portfolio to determine which investments have risen significantly in value since you purchased them. Think about when you are likely to sell. Then crunch the numbers on how much tax you’d pay by selling now or later.
Selling now means you’d be left with a smaller sum of money or other assets to grow. So factor in lost opportunities for the assets to appreciate in years ahead. Plus there’s the out-of-pocket cost.
Remember that the past decade has been an era of very low taxation by historical standards. A long-term capital gains rate of 20 percent starting in 2013 would still be relatively modest. Even the likely worst-case scenario of 23.8 percent for high earners would hardly be dire in comparison with many recent years.
The maximum long-term capital gains rate was as high as 39.9 percent in the 1970s and 28 percent for a good chunk of the ‘80s and ‘90s.
Assuming the price is right, go ahead and sell this year if you were going to do so soon anyway. That’s particularly the case with property or real estate, where the rate increase for capital gains is slightly different but the same principle applies.
A South Dakota man who had been planning to sell the family ranch he inherited from his parents is pushing the transaction through this fall. Rick Kahler, a certified financial planner in Rapid City, advised him he would likely pay at least $90,000 less in taxes by doing so than by waiting until next year.
Kahler is telling clients they should consider moving up any sale that they were expecting to make in the next 12 to 24 months. PwC, the U.S. arm of professional services company PricewaterhouseCoopers, goes even further, recommending selling any asset now that you might otherwise in the next 10 years.
It’s OK to hold off until after November elections to see if Congress and President Obama can work out a deal to put off the capital gains hike and other automatic tax increases and spending cuts.
Just be wary of waiting until the last few days of the year or you could get stuck selling at a market low.
Carefully consider the consequences of any sale on your adjusted gross income.
Selling a substantial amount of assets could drive you into a higher tax bracket than you would have been otherwise, and this would skew your math on tax savings. And you don’t want to trigger the additional 3.8 percent surplus tax on a big chunk of investment income.
Don’t rush to sell if you have capital tax losses carried over from earlier sales.
The technique known as tax-loss harvesting is generally a savvy way to reduce your tax burden. If you have sold shares of a stock or mutual fund for less than you paid, that created a capital loss for tax purposes. It can be used to offset a capital gain that you incurred by selling another stock or fund.
Taxpayers who have more losses than gains can carry them over to subsequent years indefinitely and apply as much as $3,000 per year against their regular income.
But using the tax losses this year wouldn’t go as far as they would in 2013 and beyond when you’d likely have more capital gains taxes to offset. So, no need to sell shares now just to have a gain to offset in 2012. Better to hang onto those losses and use them in later years, advises Jeff Saccacio, partner in PwC’s private company services practice.