TheLiveBigWay Digest – Cliffhanger: The Fiscal Cliff and Year-End Planning

We’ve all heard more than enough about the Fiscal Cliff that looms at year’s end and the ongoing negotiations between the White House and Congress aimed at avoiding it. As you might imagine, we’ve expended a great deal of time and energy analyzing the various scenarios in this cliffhanger with an eye toward identifying whether any year-end moves are called for on your part.  Herein we offer our take on the situation.

To Sell or Not to Sell?
Focusing first on the possibility of higher tax rates, the biggest question we’ve wrestled with is this: if capital gains rates are going to rise to 20% or more on January 1, should we sell all of your investments that have embedded gains now in order to take advantage of the current 15% rate?  A related consideration is the arrival of the 3.8% Medicare Tax on investment income in 2013. So, does it make sense to sell now and grab that low, 15% rate?

We think not. Here’s why:

Under normal circumstances, embedded gains are “realized” rather slowly in our average portfolio, generally over many years.  If we were to realize all embedded gains at once, the portfolio going forward would be smaller by an amount equal to 15% of those realized gains. If we’re in a rising market (which we are more often than not), that’s capital that is not earning a gain. There is some break-even point beyond which it is better to have deferred paying the capital gains tax, even if you end up paying it at a higher rate.

And I’m sure you won’t be surprised to hear that we’ve run the numbers.

And what a lot of numbers there were! For starters, the underlying capital gains rate will go to 20% for everyone if the current law is allowed to expire. If the President has his way, this will only apply to those taxpayers earning more than $250,000*. Under all circumstances, those earning more than $250,000 will be subject to the new 3.8% Medicare Tax on investment income, but only for that portion of their income over $250,000.  Likewise under the President’s proposal for regular capital gains, you only pay the higher rate on the lesser of your actual capital gains or the amount by which your income exceeds $250,000. To complicate things even more, allowing the current law to expire without replacing it puts us back under the 1997 law, which contained a special capital gains rate of 18% for assets acquired after 2001 and held for at least five years.

In the end, we had to consider the possibility of 15%, 18%, 18.8%, 20%, and 23.8% rates, and that assumes negotiators don’t conjur yet further possibilities! If you further assume a 7% rate of return and the complete liquidation of your portfolio on some future date (this latter assumption is extreme, of course), the number of years it takes in order to be better off for having NOT realized all of your gains this year are as follows:

Again, these calculations assume the complete liquidation of your portfolio in the specified year, which is extremely unlikely.  The bottom line is that it does not appear to make sense to sell your positions and realize gains this year unless you know that you will otherwise have to sell everything next year or soon thereafter. We believe that scenario would be the sole instance where selling now makes sense.

We hope this little journey along the edge of the Cliff was enlightening.  We’ll have more to say in the coming weeks about other implications of the year-end precipice.

The Yeske Buie Team

*we’ve made some simplifying assumptions here; for a more detailed summary, we recommend the Tax Foundation’s analysis (https://taxfoundation.org/article/250000-threshold-how-does-it-work)
Dave Yeske