Last-Minute Investment Tax Tips for 2012 (#1 in a four-part series)Capital Gains Tax Sale: Good Deal or Bad Deal?

Last-Minute Investment Tax Tips for 2012 (#1 in a four-part series)Capital Gains Tax Sale: Good Deal or Bad Deal?

Coming off the heels of Black Friday and Cyber Monday, you probably witnessed some extraordinary sales and deals in the past couple of weeks. Whether you braved the crowds at the shopping mall or not, you certainly saw television or newspaper advertisements touting flat-screen TVs for $199 or 20% off all computer equipment.

It is not just consumer goods that are on sale. Capital gains may be as well. Right now, the maximum Federal tax rate on long-term capital gains is 15%. That is scheduled to go up to 20% in 2013. While Congress may extend the 15% rate for all or at least some taxpayers, they have not done so yet. While that remains an unknown, what we do know for certain is that couples earning more than $250,000 in 2013 ($200,000 for individuals) will owe a 3.8% tax on investment income (defined as interest, dividends, and capital gains). This tax is to pay for the Affordable Care Act, and with President Obama winning reelection and Democrats maintaining control of the Senate, it isn’t being repealed. So at the very least, long-term capital gains rates will be increasing to 18.8% for so-called “high-income earners.”

This 3.8% increase (with potential for more) has prompted some investors to consider realizing long-term capital gains now in 2012 to lock in at least a 20% discount. However, while 20% discounts at the mall only mean extra money in your pocket, the same cannot be said for capital gains tax discounts. The reason is that paying taxes now reduces your capital at work in the market. While you may pay a lower tax rate now as opposed to later, you also forego the returns you can earn on the money that came out of your portfolio to pay the tax—money that would still be working for you if you chose not to realize a gain this year. For example, if you sell your $100,000 stock with a zero-basis, you will pay $15,000 in Federal long-term capital gains taxes this year. While that represents less tax than you may pay in future years, you now only have $85,000 of investment capital working for you as opposed to the $100,000 you had previously.

The effect of that reduced capital on future returns needs to be accounted for as does any state tax you may owe. We ran a scenario in which we assumed that capital gains taxes would increase to 20% beginning next year. We also included the 3.8% Affordable Care Act investment tax and state tax based on California’s schedule, which is among the highest in the nation. As our return assumption, we used 8%. The breakeven point between realizing the gain in 2012 and deferring the tax was five years.

What that means is that if your financial planning strategy included the making of a long-term gain on a security within the next few years to say pay for your kid’s college education or buy a house, you may want to consider realizing it this year instead. Your time horizon, in this case, is short enough where the benefit of the tax deferral does not have enough time to overcome the cost of the additional tax in the future.

On the flip side, if you own an investment that you intend to hold long-term (five years or more), it does not make sense to sell it now and buy it back to save on tax. At year five, the benefit of earning money on the additional capital at work begins to exceed the cost of higher taxes.

This analysis is sensitive to its assumptions, so it is important to consider your personal tax situation. (For example, in removing state tax and the 3.8% investment tax from the scenario, the breakeven point fell to four years.) In any case, it is worth remembering that taking a “discount” on capital gains in 2012 may prove more expensive over the long term.

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