Capital Gains Tax Increase - Should You Sell This Year?

Last Updated Jul 7, 2010 6:58 PM EDT

It seems pretty certain that the Federal long-term capital gains tax rate is going to increase from 15 percent this year to 20 percent in 2011. So if you're pondering whether you should sell your investments this year before the increase, here is a framework to help you decide.

A little background

Mark Patterson, tax partner with the Colorado CPA firm of Stockman, Kast, Ryan & Company notes that 2001 Bush tax cuts were temporary and will expire at the end of 2010. Patterson states it is not likely that legislation will be passed and signed to extend or make this particular tax cut permanent. Thus, a tax increase in 2011 appears a near certainty.

At first glance it would seem like a no-brainer to pay lower taxes this year, but there is another very powerful force at work - the power of compounding. By hanging on to the money that would be going to Uncle Sam to pay taxes, we can invest it and benefit from its growth. If the benefit from the future gains is greater than the tax savings from the lower rate, you are better off holding on to the security.

Tax example
To illustrate, say you have a $10,000 security with a $5,000 long-term capital gain that you think will appreciate at eight percent annually. You could sell it today and pay $750 in taxes (15% x 5,000 gain) and invest the remaining $9,250. Future gains on these funds would be taxed at 20 percent. For this example, we will assume no dividends are received.

It turns out, under these assumptions, you'd be better off hanging on to this investment if you plan to keep it five years or longer. The gain in the entire $10,000 more than offsets the extra taxes you'd pay. Granted this is a pretty simple example, combined with the fact that I pulled the eight percent annual return out of thin air, but hopefully you get the gist.

A framework to help you decide
Like any good math geek, I crunched the numbers to see what really mattered. There are only two factors you need to take into account in deciding whether to sell or hold on to your investment. Those factors are your expected annual return and the number of years you will hold the investment if you don't sell it this year. Here's a chart with the results.

Thus, if you aren't terribly optimistic and expect your return to only be four percent annually, you'd have to wait nine years. However, if you expect 12 percent annual returns, you need only wait three years.

Unless your state has a special rate for long-term capital gains and plans to change those rates next year, state taxes don't enter the equation. And it also doesn't matter whether your gains are small or large.

A farewell warning
Nothing about taxes is simple so you should use this chart only as a guideline. You may have a tax-loss carry forward or be hit with the alternative minimum tax (AMT) if you sell today. And who knows how long the 20 percent long-term capital gains tax will stay in place.

Nonetheless, selling your gains this year is not the easy decision many people seem to think. If you expect healthy returns and are a long-term investor, you may want to hang on to some of those gains. Consider the taxes you would have paid as an interest-free loan from Uncle Sam. The final silver lining to this cloud is the possibility of avoiding paying capital gains tax altogether with the current step-up provision that allows your heirs to inherit your stocks without the gains.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.