Make the Tax Man Wait

Would you rather pay a lower tax now or a higher tax later?  The easy answer might not be the right answer.

Suddenly, it seems, everyone is talking about selling profitable stock positions before the tax rate on capital gains goes up.  If you have held a stock for more than one year and you sell it at a profit before the end of 2012, the Internal Revenue Service will take up to 15% of that long term capital gain.

On 1 January, unless Congress and the White House strike a deal, the tax rate on long term capital gains will jump to a top rate of 20%.  Upper income taxpayers will owe another 3.8% on top of that as part of the Affordable Care Act.

Taking a tax hit this year to avoid a bigger one in future years can make sense for people in special situations or with short horizons.  For most investors, however, paying higher taxes later beats paying lower taxes now.  The longer you can keep Uncle Sam out of your pockets, the more wealth you should be able to build.

If you sell a stock in 2012, you can immediately buy it back and as the jargon goes, "reset your basis."  You once again hold the same position, but at a higher purchase price than before.

It is a trade off.  Sell this year and your gains will be taxed at a minimum of 15%.  But the immediate tax hit leaves you with less money to invest upon which you can earn future gains. 

On the other hand, the decision not to sell exposes you to the risk of paying taxes at a much higher rate down the road.  But it does ensure the 100 cents on the dollar will rise tax-deferred along the way - assuming, of course, that the markets produce positive returns.

The longer you want to stay invested, the higher your anticipated return and the lower the rise you expect in the capital gains rate, the more inclined you should be to stay put.

In many cases it makes sense to defer your capital gains into the future even if tax rates do go up.

If you have a holding that you were going to sell in the next 12 months anyway, then selling it before the end of 2012 makes sense.  Also, you probably should sell if you need the cash or you think the investment is overvalued.

Source:  Jason Zweig, Wall Street Journal

The information contained in this article does not constitute a recommendation, solicitation, or offer by D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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