“Don’t let the tax tail wag the investment dog”! Normally this is true. Tax decisions should be made in conjunction, but secondary to investment decisions. Keep reading to find out why, right now, the dog should, in fact, follow his tail.
First, tax harvesting is a strategy used to capture losses typically at year-end. These losses are then offset against realized capital gains. The tax tail in this article is not the capture of losses, but rather the realizing of long-term gains. Waiting until the end of the year to take action could be a mistake.
The Bush tax cuts are set to expire at the end of this year. With the political uncertainty sure to continue in Washington DC, an extension of the cuts is questionable. If by some miracle Congress and the President-elect can come to an agreement on a revised tax system, you can be sure it will include higher “effective” rates (rate you actually pay). But if they do nothing, the 15% capital gains rate enjoyed for the last several years will expire and revert back to 20% (for most assets). A five percent increase on a $25,000 gain means you would owe an extra $1,250 in taxes.
Unfortunately the tax impact gets even worse for those in higher tax brackets because of the new unearned income Medicare contribution tax. This new tax will affect married couples with $250,000 or more of modified adjusted gross income (MAGI) and single individuals with MAGI of $200,000 or more. This new tax adds an additional 3.8% of taxation on the lesser of excess income or net investment income. Here’s a quick example of how the tax is calculated. Suppose a husband and wife have a combined salary income of $275,000 and investment income of $50,000 from capital gains and dividends. Their MAGI is $325,000 (they have no foreign income or housing exclusions). They owe 3.8% multiplied by the lesser of the excess income over $250,000 (or $75,000) or net investment income of $50,000. Therefore, they owe an additional $1,900 (50,000 x 3.8%) in tax.
Starting next year many individuals will potentially face an 8.8% (5%+3.8%) increase in taxes from investment assets. Many individuals will realize this onerous impact at year-end (or whenever the media catches–on) and there may be a wave of selling. How much this selling will impact prices is difficult to know exactly, but anytime there is more selling than buying prices drop. Capturing gains now, before the crowd, may be a great strategy.
What are the risks? Well, the Bush tax cuts could be extended, but for how long and for whom is uncertain. By some surprising political cooperation, the tax code could be revised entirely and result in lower tax rates. Finally, the new unearned income Medicare tax could evaporate with the demise of the Affordable Healthcare Act that it was designed to help subsidize. This last point has the most likelihood of materializing. Aside from these risks, there is no rule preventing you from selling your position at any time throughout the year and realizing a gain. You can then buy it back the same day or the next day, reset your cost basis, and avoid a big price movement.
A warning, if you do sell to capture a loss, beware the wash-sale rules. Wash-sale rules apply to captured losses not gains. So if you are selling positions at a loss and want to use that loss to offset gains be careful. In order to recognize the loss you must stay out of the position (or “substantially identical” position) 30 days before you sell your existing holding and for 30 days after the sale. If you do believe that tax rates are going up then you may want to hold-off capturing losses to future years so you can use them to offset future high capital gains rates.
In summary, selling now to capture long-term capital gains ahead of the crowd may result in a higher sales price and a lower tax rate compared to waiting. Before implementing any strategy, always consult your tax advisor to understand the tax implications.