A recent article in The Economist talks about the reasons to stick with low cost ETF’s and proper asset allocation for the long term success.

“The best way for investors to play the odds is to choose low-cost ETFs or trackers and diversify geographically and across asset classes. It is not an exciting strategy. It will not bring anything to brag about at dinner parties. But it will mean that more of their money stays in their own pockets, and less goes to buy other people’s mansions in Mayfair and the Hamptons.”

Remember, successful investing is not supposed to be glamorous.  Find something else to chat about this holiday season and your retirement accounts will thank you for it!

The daily fiscal cliff news coverage is causing irrational investor behavior regarding unrealized long-term capital gains (LTCG).  Without congressional action the LTCG rate is set to increase from 15% in 2012 to 20% in 2013.  In addition, high earners are subject to a 3.8% Medicare surtax applied to all capital gains. (income greater than $250,000 for married filing jointly, $200,000 for singles, $125,000 for married filing separately).  The proposed tax rate changes are far from certain and may not be resolved well into 2013.

In order to accurately determine if a year-end sale is the right decision, the pros and cons must be weighed against each other.

Reasons to sell appreciated assets by year end

  • When the money is needed – If the money is needed this year or in the near future, take advantage of the guaranteed 15% LTCG rate.
  • Rebalancing needs – Selling an asset as part of a routine rebalancing process is another good reason to sell an asset by year end.

What are you giving up?

  • Charitable donation step-up basis – If charitable giving plans are in the near future, realizing the gains now would result in unneeded taxes paid.
  • Estate step-up basis – Under current law, all appreciated assets get a step-up in basis upon death.  While this will not help the owner of the stock, the estate, spouses and heirs could greatly benefit by this rule.
  • Built Up Long-Term Losses – Long term losses will become 33% more valuable if the capital gains rate goes up to 20%  (59% more valuable if the 3.8% Medicare surcharge is applicable to you).
  • Smaller Tax Bill – Selling assets with long-term capital gains will increase the 2012 tax bill.  Another item that is often not considered is the Alternate Minimum Tax (AMT).  A large long-term capital gains sale could easily trigger AMT on an individual’s tax return negating the small benefit of selling the gains prior to a rate increase.

Payback Period
The year end tax planning decision is purely a factor of when the assets will be needed.  An example is the best way to look at the situation.  If an investor has a $100,000 LTCG and sells them in 2012, that investor will have a federal income tax bill of $15,000, excluding AMT implications.  If that investor were to buy back the stock, they could only use the remaining $85,000.  Over time the $5,000 tax savings (between a 15% and 20% LTCG rate) would be offset by the compounding interest realized by the $100,000 investment over the $85,000 investment. With average real market returns of 6%, the payback of holding LTCG is less than 6 years.

The table below depicts the required number of YEARS that LTCG must be held to come out ahead of the potential tax changes in 2013:

New LTCG Tax Rate

Real Growth Rate (Excluding Dividends)

2%

4%

6%

8%

10%

20%

17.5 yrs

8.9 yrs

5.9 yrs

4.4 yrs

3.5 yrs

23.8% (20% + 3.8%)*

27.4 yrs

14.5 yrs

9.8 yrs

7.3 yrs

5.8 yrs

*This rate applies to high income earners

The long term capital tax rates remain uncertain.  Making portfolio decisions based upon a potential tax law change is a mistake for both clients and advisors.  While each situation is unique, there is no compelling reason that realizing capital gains now is a better decision than doing nothing.