Two weeks ago, I wrote about the new super-long-term tax rates that came in to play this year, beginning Jan. 1, 2001. To sum, if you purchase an investment after Jan. 1 of this year and hold for at least five years, you're eligible for the super-low capital tax rate of just 9% or 18%, depending on your tax bracket.
There is also an option to convert your current holdings to super-long-term eligibility by ostensibly selling them on Jan. 1, 2001 for fair market value on that day and buying them back for the same price and paying any capital gains taxes due. This is a retroactive event that you can invoke up until you file your 2001 tax return.
So, now you ask, should I convert any of my holdings to obtain super-long-term eligibility? The answer depends on how much your investments have appreciated and on a reasonable expectation for future growth on that investment. For illustration, I whipped out my nuclear-powered abacus and ran some numbers on the Drip Port's holdings. From the results, I provide two examples.
We'll begin with our most recent Drip Port purchase. Prior to Jan. 1, 2001, we made just two purchases of PepsiCo (NYSE: PEP). Although it might seem like a no-brainer to convert these shares since we're currently at a loss (based on the price as of this writing), remember that the conversion price is fair market value as of Jan. 1, 2001. Using the closing price of Dec. 29, 2000, our soda had a little pop, showing us a total gain of $13.32. I arbitrarily chose a short-term capital gains tax rate of 28%. If we were to convert our shares of Pepsi at that rate, we'd pay $3.73 in conversion taxes.
Now, let's look at that $3.73 growing at our historical annual growth rate of 11.68%. After 20 years, the $3.73 we would lose in capital gains tax would grow to become $33.98. That's the opportunity cost of making the conversion. Would the reduced tax rate earned through conversion make up that cost?
Using again the closing price for Pepsi on Dec. 29, 2000, the value of our holding was $303.32. Growing this amount at our historical rate over 20 years would land us $2,473.20. The current long-term capital gains tax rate for this experiment would be 20%, leading to $494.64 in taxes after removing our cost basis of $290. Taking the same amount and applying the new super-long-term tax rate of 18%, in this case, we end up paying $445.18, a savings of $49.46. The conversion in this scenario would save us $12.38 (20% of the opportunity cost was subtracted for taxes, also).
Now let's look at our largest holding, Intel Corp. (Nasdaq: INTC). Prior to the beginning of 2001, the Drip Port had purchased 52.2886 shares of the chip that chimes. Based on the closing price on Dec. 29, 2000, those shares had a value of $1,571.05. Our basis for Intel is $1,301.42, leaving a gain of $269.63. We'd need to divide the long-term holding period shares from the short-term, and apply the proper rate for each. In this example, we used 28% for short-term and 20% for long-term. Conversion of Intel to super-long-term would cost us $59.10 in taxes this year.
Running the opportunity cost calculator again at the same rate of growth would mean we would be sacrificing $538.39 after the conversion. Subtract 20% capital gains tax and we have $430.71.
Using the same process as outlined for Pepsi, after 20 years our stake in Intel after conversion would be $14,311.93. Subtracting our cost basis of $1,301.42, we're left with a gain of $13,010.51. Looking now at the two tax rates, we arrive at $2,602.10 for the long-term rate and $2,341.89, for the super-long-term rate, a difference of $260.21. In this scenario, we'd end up losing $170.50 when all is said and done. So, we shouldn't convert these shares based on this experiment.
The numbers will vary depending on growth rates, your personal tax rates, and the amount of gain you earned as of Jan. 1, 2001. I ran the numbers on all five of the Drip Port's holdings using a few generic rates, and it was advantageous to convert Pepsi, which gained very little at year's end, and Campbell Soup (NYSE: CPB), which was negative.
You should run the numbers for your holdings or visit a tax professional to determine if it is worth converting your investments. Chances are that only those holdings with minimal or low gains will be worth converting.
For other tax issues, visit the Fool's All About Taxes area. For questions, ask on the Tax board there, or ask us on the Drip boards linked above and to the right.
Vince Hanks drank a diet Pepsi while writing this column, but he does not own stock in PepsiCo. Nor does he own shares of Campbell Soup. To see the stocks he owns, which includes Intel, view his profile. The Motley Fool is investors writing for investors.