Now that the 2012 election is behind us, we finally have some certainty about which political parties will control which branches of government. The fiscal landscape, however, remains to be decided, as both Democrats and Republicans are expressing a desire to avoid the looming Fiscal Cliff but have very different visions on how best to accomplish that.
Whatever path the negotiations take, we believe it is safe to assume that some changes to the taxes levied on investment income are coming in 2013. The Affordable Care Act imposes a new 3.8% Unearned Income Medicare Contribution Tax in 2013; meanwhile, the potential expiration of the Bush tax cuts and tax hikes to capital gains and dividends are looming.
The table below shows both the current and expected rates for 2013.
For all investors, increases in tax rates will make tax-efficient investing more important than ever. Prudent asset location, portfolio structure and investment selection will be critical to maximizing after-tax returns. For investors with significant capital gains, they now also have an important and complex question to answer:
Is it better to realize a capital gain today in a lower tax environment or continue to defer the tax liability and risk liquidating in a higher tax environment?
This question can be addressed by understanding what we call the “Liquidation Hurdle”. The Liquidation Hurdle is the amount by which the future capital gains tax rate must increase in order to justify selling today.
The Liquidation Hurdle is affected by three factors:
1. Expected Future Tax Increase
2. Expected Future Return
3. Expected Future Investment Horizon
By calculating the differences in an investor’s terminal wealth by making assumptions about these three factors, we can help clarify whether it makes sense to “Pay Now” or “Pay Later”.
In Example 1 below, if the expected return is (2%) and the investment horizon in (5 yrs.) the hurdle rate is relatively low at just 1.3%. In other words, the capital gains rate would only need to increase from 15% to 16.3% to justify selling today.
In Example 2, if an investor has a 20 year investment horizon and an 8% expected return, Long-Term Capital gain rates would have to increase 30.1% to 45.1% from the current 15% to justify selling today.
As you can see, making a decision to “Pay Now” solely on the basis of a pending hike in tax rates is misguided. We must make that decision in conjunction with expectations on future expected returns and investment horizon because the benefits of tax-deferral remains very powerful.
The power of tax-deferral is generated by the compounded earnings on the monies you didn’t pay in tax. If you pay $50,000 today in taxes, that money will not be there to generate a return for you in the future. The longer that money would have been invested or the higher the return it would have earned, the more valuable it becomes and the more beneficial it is for you to hold on to.
But enough theory. The question is, what should you do now?
If Congress adopts a do-nothing strategy and the Bush tax cuts expire, the long-term capital gain tax rate will increase to 23.8% from its current 15% rate. Investors with short time horizons or very low expected return assumptions (inside the yellow dotted line) may find it beneficial to pay taxes now at the lower rate. For those outside the outlined area, it is likely more beneficial to stay put and pay later.
This table is a great starting point but is no substitute for a thoughtful conversation with your advisor about your unique situation. Please do not hesitate to call to discuss whether Pay Now or Pay Later makes sense for your situation.
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