Since many tax laws change each year, it's smart to keep up with how those changes may affect you. The latest development in our tax code could make this year or next a great time to harvest some of your capital gains.
As our representatives in Washington try to deal with a massive deficit, many people reasonably expect various tax rates to rise in coming years. For now, however, capital gains tax rates are enjoying a bit of a reprieve.
Before May 2003, the maximum tax rate on long-term capital gains was 20% for all but those in the lowest tax bracket, who paid 10%. Since then, those rates have sunk to 15% and 0%, respectively. With many possible tax hikes on the table, legislation passed at the end of 2010 kept the rates steady through Dec. 31, 2012. After that, though, rates may well revert to previous levels.
Examine the big picture
If the thought of facing a 20% or greater tax rate on your gains has you planning to sell, hold on. In general, while it's good to factor tax considerations into your investment decisions, you need to base your buying and selling decisions primarily on investment merits.
After all, while rates may indeed rise beginning in 2013, they may not. Washington has a much harder time raising taxes than lowering or extending them. Even if they do rise, and you're sitting on a stock that you expect to grow like gangbusters over the coming years, you can still profit handsomely if the tax rate is 20% or 25%.
Still, a little planning can be worthwhile. Consider all your options:
- You can do nothing. If there's a higher tax rate later, you'll pay more in taxes.
- You can plan to close out your positions in various holdings, selling out of qualifying appreciated assets this year and next in order to take advantage of our current lower rates.
- You can plan to maintain your position in those holdings while still taking action. Consider selling out of qualifying assets by the end of 2012, then buying them back. Because the "wash sale" provisions don't apply to gains, you don't need to wait 30 days before you buy the asset back. When you buy a holding back like this, you'll have a new, higher, cost basis on which to base future gains calculations.
You might also consider spreading out your gains a little over this year and next, so that you're not hit too hard in one year. Realizing many thousands of dollars in gains can put a lot of pressure on your budget, even at the 15% rate. A total of $25,000 in gains will amount to $3,750 at 15%. If you can't afford to pay for all your gains in the coming two years, you might want to recognize only some of them.
Assets held in tax-advantaged retirement accounts don't get hit with taxes on capital gains each year, so this issue is moot for them.
Remember also that short-term capital gains, resulting from assets held for a year or less, don't qualify for these rates. They've long been taxed at your ordinary income tax rate, which is 25% for many of us, and can be as high as 35% for some of us. Frenetic short-term trading often leads to extra commission and tax expenses, as well as lower returns, so having lower tax rates available for long-term gains is a nice incentive to be patient. After all, long-term investing has made many people wealthy.
As you ponder buying and selling various securities in the years ahead, remember that tax considerations can affect your profits, and start thinking strategically.
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Longtime Fool contributor Selena Maranjian appreciates your comments. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.