Reader Kevin asked:
"I have several mutual funds with large unrealized capital gains. I expect tax rates will go up in the future. Does it make sense to sell them now while the capital gains tax rate is still low, repurchase them immediately after, and reset my cost basis?"
The answer, as usual, is "it depends."
It depends on when one expects to eventually sell these funds, to what extent the tax rates will go up, and how fast these funds will grow.
First of all, the concern for tax rates going up is legit. For high earners, the administration already proposed to raise the capital gains tax rate from 15% to 20%. There’s also that new 3.8% Medicare tax on unearned income starting in 2014.
Selling and repurchasing immediately is totally legal. Wash sale rules prevent an investor from taking a loss if substantially identical securities are repurchased right away. They don’t prohibit repurchasing the same funds immediately after realizing a gain.
However, resetting the cost basis this way will accelerate tax payment from the future (at an expected higher rate) to the current year (at a lower rate). There’s a tradeoff between the rate difference and the loss of tax deferral.
The tradeoff favors resetting the cost basis now if:
- the investor expects to sell these funds in the near future anyway; OR
- the investor expects the tax rate to go up a lot; OR
- the investor expects a low growth rate from these funds
The tradeoff favors holding the funds and doing nothing if:
- the investor expects to hold these funds for many years; OR
- the investor expects the tax rate won’t go up too much; OR
- the investor expects a high growth rate from these funds
Given a long enough holding period and a high enough growth rate, the tax deferral can overcome a higher tax rate. How long is long enough? We need another spreadsheet! I created one to quantify the tradeoff. For example, under the following set of assumptions, the investor is better off resetting the cost basis if the expected holding period is 9 years or shorter.
|Tax rate now (including state tax)||20%|
|Tax rate in the future||30%|
The answer will be completely different under a different set of assumptions. You will have to play with the spreadsheet and see how it comes out with your own assumptions.