Tax Planning for the Fiscal Cliff: The Strategic Perspective

We recently posted an analysis of the tradeoffs involved with realizing embedded capital gains in 2012 before presumed higher rates kick in starting January 1 (Cliffhanger: The Fiscal Cliff and Year-End Planning), in which we focused largely on the tradeoff between keeping more capital invested and eventually having gains taxed at a higher rate.  We want to now return to the topic with more emphasis on the strategic dimension. As always, the numbers can only take you so far when making decisions in the face of uncertainty so we’ve summarized some of the “key drivers” below:

1. A low-turnover portfolio is going to release gains very slowly over very many years. Depending on the tax rate you assume, the break-even point is anywhere from 3 to 9 years and THAT assumes that you completely liquidate the portfolio at the end.
2. It goes without saying that beneficial lot accounting (which we use) slows that gain release even more than would be the case with average cost accounting.
3. The proposed higher rates for cap gains, as well as the new Medicare tax, apply only to gains above some threshold.  We don’t yet know what the threshold will be for cap gains, though it looks like it might end up as high as $500,000, the number Warren Buffet suggested in his recent NY Times piece – as you may recall, President Obama offered to move the threshold up to $400,000 before talks with Speaker Boehner broke down. Even wealthier individuals often have Adjusted Gross Income (AGI) below $250,000 and certainly below $500,000, especially retired ones (less likely, perhaps, with those who derive most of their spending from IRAs, but capital gains rates are a moot point for them anyway).
4. Given a worst case scenario of complete expiration of the Bush tax cuts for everyone, followed by gridlock in Washington, realizing all gains today would mean that you’re grabbing a 15% rate on current embedded gains but giving up the chance to have gains over the next 5 years taxed at 18% versus 20% (assuming you only ever liquidate share lots with 5-year gains).
5. At the most fundamental level, we don’t believe that our current political environment supports making all-or-nothing kinds of decisions.  From a purely strategic standpoint, you have to properly weigh the uncertainties.  Whatever happens in the next five days or the weeks following, there’s a good chance that we’ll have comprehensive tax reform in 2013/2014 and who knows what rates will look like or how smart a sell-it-all-now strategy will look in hindsight.
6. In conclusion, we believe that if any positive case can be made for holding off, the enormous uncertainty surrounding the emerging tax landscape favors a wait-and-see strategy.

Of course, there are several scenarios in which selling now is unambiguously indicated.  In any situation where assets are going to be sold within the next year or two, they should be sold now. There are no probable scenarios that have rates falling in the future and a number of them where rates may rise even for those with more modest incomes.  However, for timing horizons beyond the next few years, we believe the uncertainties favor a more cautious approach to realizing gains.

The Yeske Buie Team