Could Be Time to Harvest…A Long Term Perspective

Monday, April 26th, 2010 by Charles Mayfield, CFP®

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There is much to be said for the financial opportunities afforded us in 2010.  You can look at any number of the recent postings to get a good feel for what is going on.

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I feel it is prudent to discuss another monstrous opportunity that exists this year. This isn’t about income taxes.  I’m talking about taxes owed on long term capital gains.  When you purchase an investment in an after-tax account your purchase price establishes your cost basis.   When you sell that investment, you will owe taxes on the gain.  Assuming it was owned it for 12 months plus 1 day, you will owe the more favorable long term capital gains tax.  Currently, long term capital gains (LTCG) are taxed at 15% (unless you are in a 10-15% income tax bracket).

The long term capital gains tax rate is set to increase to 20% in 2011.  This presents a unique opportunity to harvest some gains on your after-tax portfolio in 2010 at the lower rate.  If you’re a savvy investor and made some well-timed investments in the market a year ago (the market low was March 9th), you are likely looking at some sizable gains in your portfolio.

Selling the investment now allows you to realize some of those gains.  Putting that money right back to work in the market would reset your cost basis at a point higher than your original investment.  Here is an example:

Approach 1
John invests $100,000 in XYZ company on March 1st, 2009.  Today, that investment is worth $130,000 (it was a pretty good year in 2009).  Assuming John sells the investment today and realizes a $30,000 gain, he would owe 15% tax on the gain ($4,500) when he files his taxes for 2010.  John takes $4,500 and sticks it in his savings account to pay the future tax liability.  The remaining proceeds, he reinvests.  His new cost basis is now $125,500.  Fast forward (a year later) to April, 2011.  John’s investment is now worth $163,150 (another stellar year of returns).  If John decides to sell his investment, he will owe LTCG Tax on the gain.  $163,150 minus $125,500 equals a $37,650 gain.  Taxes due on that transaction would be 20% (the new LTCG rate) or $7,530.  John’s original $100,000 investment is now worth $155,620 (after taxes).

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Approach 2
John makes the same investment in XYZ on the same date.  Only here, he holds the investment for the entire 2 years.  He keeps his $4,500 in taxes owed (from approach 1) in the market and it continues to grow.  In April, 2011, John sells his investment for $169,000.  He will pay taxes on the entire gain ($69,000) at the higher tax rate of 20%.  This nets him $155,200.  The extra $4,500 he had working for him in the market for that year was negated by the effective 33% increase in taxation of his gains (from 15% to 20%).

Note: This illustration uses a 30% annual rate of return.  This is not typical. 

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Taxes on gains are inevitable.  The idea that any investment is worth the amount printed on your statement just isn’t true.   You must always account for the taxes due on any gains.  Talk to your advisor today about how best to position your money for the long term.  If you can ‘pay the piper’ now by capturing some gains, that could reduce the impact of that future long term capital gains tax rate hike.

Note:  It is important to note that this strategy also holds true to capturing Long Term Capital losses.  Since losses offset gains on a dollar for dollar basis, John could use any losses to offset future gains.  This also presents an opportunity to take advantage of the tax rate hike.

 

This is a hypothetical example and is not representative of any specific situation. Your results will vary.  Past performance not indicative of future results.

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