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.
Say No To Management Fees
If you are paying an advisor a percentage of your assets, you are paying 5-10x too much. Learn how to find an independent advisor, pay for advice, and only the advice.
I will probably not sell anything until retirement, but the increased capital gains tax still initially concerned me. However the increase (+5%) will be balanced out because I plan to move out of New York State before I retire (-6.85%).
Also, I have lots of capital loss carryover. So if I can drag it out for enough years, I can put $3000 per year against my normal income (25% + 6.85% = 31.85%), so I will get much more benefit from not resetting my basis.
More support for your point that it’s different for every person. I treasure my capital loss carryover like money in the bank, so I wouldn’t do anything to squander it.
Random Poster says
Jacques Boutet says
In addition to the three independent variables you identified, you can add several others (life expectancy, event-driven financial needs, yadda, yadda, yadda) that reinforce the simple philosophy of buying and never selling.
I’ve worked plenty of models on re-financing mortgages and Roth IRA conversions and learned that even when you can establish quantifiable boundary conditions (for example: the ultimate costs of various loan options or the size of the tax event with a retirement account conversion) there is still subjective risk in the equation.
I set aside a (small) portion of personal brokerage account for scratching my “gaming” itch. After 15 years, all I’ve got to show for it is some entertainment value, not unlike a Saturday night poker game.
I recommend that Kevin hang tough. It will be a much different world in ways we can barely imagine when he starts his withdrawals. On the other hand, the Federal government could sure use his money right now.
Robert Leingang says
Your article on resetting has me thinking. You say each situation is different Here’s mine! What is the effect on my federal taxes if we sell enough stock this year to to pay off our mortgage? We owe about $98,000 on a 1st mortgage at 5% with a payment of $671/month. Our AGI is approximately $27,864, deductiions of $18,127 with a tax liability of 0% filing jointy. The stock we would sell: COST and JWN each has a cost basis of about 5%. Are we better off tax-wise to reset the cost basis and then sell the stock at the higher cost basis this year and pay off the mortgage? Would it make better sense to do the reset this year and two payments: Say, half now with the balance payable in 2012? There are no state implications as we live in the Seattle area.
Harry Sit says
@Robert Leingang – At that income level, definitely consider taking advantage of the 0% long-term capital gains tax rate to reset your basis. See
Reset Cost Basis Higher By Realizing Capital Gains