September 2008

One of the differences between the presidential candidates is their tax policies. Current tax rates arise from two pieces of legislation supported by and signed into law by President Bush during his first term, as follows:

  1. The Economic Growth and Tax Relief Reconciliation Act of 2001 lowered ordinary income tax rates for individuals.
  2. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced tax rates for long-term capital gains to 5% and 15%.

Both of these tax cuts are scheduled to expire on December 31, 2010 if not extended or made permanent. Regardless of the presidential election result, a Democratic majority in both houses of Congress is likely. Senator Obama will not likely wait until the tax cuts expire in 2010, and is expected to propose immediately raising capital gains tax rates to the 28% that existed during President Clinton’s administration. In contrast, Senator McCain supports making the Bush tax cuts permanent, leaving capital gains rates at 15%.

Normally, a taxpayer is motivated to delay taxes, since taxes reduce the amount available to invest. This is the rationale for investing in 401(k) and similar tax-deferred plans. For example, assume you have $100 of built-in gain in your portfolio. If you sell now and pay capital gain tax of $15 (15% of $100), you have only $85 of gain to reinvest on a going-forward basis. Conversely, if you hold, you pay no capital gain tax now and the entire $100 of built-in gain continues to earn a return for you. Over time, this difference becomes magnified if one is fortunate to obtain higher investment rates of return.

However, if tax rates are going to increase, taxpayers are potentially motivated to do just the opposite, thereby incurring an accelerated but smaller tax. Stated otherwise, an investor with built-in gains in the portfolio may be motivated to sell winners before the tax increase. Even though this results in less money being available, the investment results may not pay for the higher taxes that are subsequently due.

If an Obama victory occurs, this raises the question of whether a taxpayer with accumulated capital gains should purposefully accelerate the capital gains in order to pay taxes at the lower current rates that currently exist. A similar question occurs with a McCain victory, although probably a year later.

With these two offsetting and contradictory forces at play, a sound decision requires calculations which consider the change in tax rates and the time period that one could otherwise forestall the tax obligation. To assist with what might otherwise be complicated calculations, the following interactive tool assists in answering:

  1. What is the difference in gains in my investments if I hold (i.e., do not sell before the expiration of the Bush tax cuts), as opposed to selling and reinvesting my after-tax gains?
  2. If I hold because I want more of my gains working for me (see question 1 above), how long would it take for the additional growth in my built-in gains to offset the cost of being subject to higher future capital gain rates?
  3. Given my investment time horizon, should I sell now (i.e., before a tax rate change) and reinvest the remaining gains, or hold until my investment time horizon ends? What is the benefit or lost benefit of selling now?

The answer to these questions depends on two variables, each of which can input into the calculator:

  1. Future capital gain rates – The higher the future capital gain rates, the longer you must hold your investment to come out ahead.
  2. Future rate of investment returns – The lower the future rate of return on your investment, the longer you must hold your investment to make up for the higher taxes.

One can also address the question by starting with your expected holding period. The following graphic allows you to input the expected holding period of the investment, and see whether one should sell now (a positive number will be shown) or continue holding (in which case a negative amount from the sale is shown).

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1 The 5% capital gain rate applies only if the taxpayer’s regular tax rate is lower than 25%. All others generally are subject to the 15% capital gain rate. In tax year 2008, the 25% regular tax rate begins at taxable income of $32,550 for single and married filing separately filers, $65,100 for married filing joint filers, and $43,650 for head of household filers. In the rest of this article, Fulcrum assumes that the reader is at or above the 25% r