A long time ago, when I was young and naïve, the tax system was able to shock me. Not anymore.
When Congress passed the Tax Reform Act of 1986, it eliminated all installment sales. Things immediately got expensive for lot of nice, sweet old men I knew—and lots of others as well.
Many people had planned to pay the taxes on their installment sales over a 20-year span. Suddenly, they were forced to pay tax on the full capital gain—even though they would not receive their funds or profits for another dozen years or more. Can you imagine the hardship?
Why bring up ancient history now? To alert you that we cannot rely on our legislators to look out for the interests of responsible taxpayers who try to do sensible tax planning. There is no way to predict if taking action today—and selling your stocks now—is a better move than following your original plans.
A very interesting analysis by PwC’s Personal Financial Services team discusses the tax realities of cashing in on your capital gains right now, to reap the lower tax rates.
What are the incentives to cash in this year?
This year, through December 31, 2012, the federal long-term capital gains rate is 0 percent for taxpayers in a 15 percent tax bracket or below and 15 percent for everyone else, plus your state’s rates. Next year, the minimum capital gains rate will be 20 percent, and it could be higher.
In addition, there will be a Medicare tax of 3.8 percent on investment income. We will also see the return of the personal exemption and itemized tax deduction phaseout for those with adjusted gross income in excess of $200,000 (single) and $250,000 (joint).
With that in mind, many investors are feeling pressure to harvest their capital gains now, while the rates are low.
If you do that now, what will the overall tax impact be?
1. You will raise your overall adjusted gross income (AGI), which:
- can reduce a variety of your itemized deductions.
- can reduce or eliminate your right to a variety of tax credits.
- can reduce or eliminate your right to contribute to IRAs.
- might end up raising your AGI enough to generate alternative minimum taxes.
2. You will also need to pay state and local taxes on the profits, and your state may not have any favorable rates for capital gains.
3. You will have cashed out and paid taxes prematurely—for nothing—if the tax rates are reduced later or in the next administration.
4. Worst of all, you no longer have all that money you’ve just paid out on taxes.
What if you didn’t sell in 2012 and then don’t pay $25,000 worth of taxes in April 2013? Look at the future value of this money over five years using a rate of return as low as 3.5 percent. If you didn’t pay those taxes, five years later you would have nearly $30,000 more than you have today—and the underlying, profitable investment would also be growing in value.
So, while it is an excellent idea to explore the benefit of cashing out your capital gains this year, be sure to take into account all the other financial considerations aside from the low IRS tax rates in 2012.
Eva Rosenberg, EA is the publisher of TaxMama.com , where your tax questions are answered. Eva is the author of several books and ebooks, including the new edition of Small Business Taxes Made Easy. Eva teaches a tax pro course at IRSExams.com and tax courses you might enjoy at http://www.cpelink.com/teamtaxmama.