pay tax now vs later, in taxable account

[JohnEyles]

Most discussions of whether it makes sense to pay taxes now,
or pay them later, is in regard to the efficacy of a conversion to
Roth IRA. To a first approximation, it makes sense to convert
if you expect a higher tax rate when you'll withdraw the money.

I am not trying to re-open that discussion here, but rather to
propose that the mathematics are VERY different when we're
talking about whether or not to reset one's basis on assets in
a taxable account. That is, to sell a position with the intent
of re-investing the proceeds, either to re-allocate or to simply
move to a better (e.g. lower OER) fund.

Let's say I'm thinking of reseting a position that's worth $125K,
of which $25K is capital gain. (I'm assuming the gains are all
long-term, and that I'll pay the taxes with other money,
reinvesting all $125K). Conventional wisdom might say
"of course it's a good idea to do this, capital gains tax will
very likely be higher down the road". But this is different
than the Roth conversion decision, because "down the road" I
will STILL have to pay cap-gains tax on the additional gains
(above the reset basis of $125K). So the $25K * 15% tax
I might pay today, is an investment whose return is only
$25K * X%, where X% is the future cap-gains taxrate. So,
if I cash in the posion 25 years from now, even if the
cap-gains tax has increased to 30%, my ROI on that money
(with which I paid the tax) is only about 3% (annualized).

Maybe everyone else knows this, but it just dawned on me,
and I think this analysis makes sense (I hope my explanation
is adequate).

It certainly complicates the decision of whether or not to sell
some sub-optimal funds, with significant cap-gains, to replace
with better ones !

[packrat44]

My intent is to sell and buy back all equity in my taxable accounts in 2010 to capture the 15% Cap gains tax rate and thereby reestablishing a new cost basis. In 2011 the Cap gains rate reverts back to the rate in 2000 at 20%, unless otherwise changed.

[Dawg54]

Originally Posted by packrat44

My intent is to sell and buy back all equity in my taxable accounts in 2010 to capture the 15% Cap gains tax rate and thereby reestablishing a new cost basis. In 2011 the Cap gains rate reverts back to the rate in 2000 at 20%, unless otherwise changed.

If everyone does this, we could be in for a massive sell off. Of course you might be able to buy back cheap.

[JohnEyles]

Originally Posted by packrat44

My intent is to sell and buy back all equity in my taxable accounts in 2010 to capture the 15% Cap gains tax rate and thereby reestablishing a new cost basis. In 2011 the Cap gains rate reverts back to the rate in 2000 at 20%, unless otherwise changed.

Yes, and the point of my original post is: if the rate remains at 20%
thereafter, and you finally cash in the position in 20 years, you'll have made
an cumulative return of 33% on the money you use to pay taxes in 2010, for a
whopping annualized return of 1.45%. (Granted, it's a tax-free return).

[LOL!]

Originally Posted by Dawg52

If everyone does this, we could be in for a massive sell off. Of course you might be able to buy back cheap.

You forgot about the "buy-back" part would occur virtually simultaneously. There will be no massive sell-off.

I prefer to die and my heirs will not pay any capital gains taxes since step-up basis is tax-free.

[packrat44]

Originally Posted by JohnEyles

Yes, and the point of my original post is: if the rate remains at 20%
thereafter, and you finally cash in the position in 20 years, you'll have made
an cumulative return of 33% on the money you use to pay taxes in 2010, for a
whopping annualized return of 1.45%. (Granted, it's a tax-free return).

If you have generated say $400K in capital gains, that 5% savings (15% vs 20%) is $20K. For me that additional $20K is worth the action taken.

[bots2019]

Originally Posted by packrat44

If you have generated say $400K in capital gains, that 5% savings (15% vs 20%) is $20K. For me that additional $20K is worth the action taken.

It took me awhile and several calculation in excel to completely get JohnEyles' point, but I think he's right on. The absolute values don't matter (whether it's 400K or 4K), the holding period is what determines whether taking action is 'worth it'.

For example, if you've got $400K in capital gains, you'll have to pay 60K now to avoid paying 80K later (assuming a future CG rate of 20%). If 'later' means two years from now, you've earned an effective annual rate of over 15%; however, if 'later' is 25 years from now you're earning less than 1.2%.

This clearly isn't a open and shut issue - if you're looking at a projected holding period of 10 years, the guaranteed (after tax) return of 7.2% is quite attractive. If you're not going to take the gains now then you'd better plan on holding them for awhile to make it a good decision.

[walkinwood]

Excellent point by JohnEyles. I did a simple calculation and it shows that you come out ahead if you delay realizing your capital (and pay 20%) than if you you realize your capital gain today and pay 15%. The reason is, as JohnEyles points out - you have to pay the 20% on your unrealized gains over the future period. And, during that time, the amount you paid in taxes is not working for you.

My calculation assumed that you sell again in 20 years. I don't know if the length of time or the investment return percentage makes a difference.

I take this to mean that I should sell only for funds or to balance my assets - not to bring up the cost basis.

Thank you!

[donheff]

Originally Posted by LOL!

I prefer to die and my heirs will not pay any capital gains taxes since step-up basis is tax-free.

Darn, I hadn't yet taken that factor into account in my spend it planning. I was assuming that I should spend down all the taxable funds first so I would pay lower taxes. But that will leave tax advantaged funds to go to the kids and they will have to pay tax on them. If things are looking rosy a few years out it may make more sense to take the inevitable tax hit on the sheltered funds now and pass the taxable stuff on in my estate.

ARRRR, where be the spreadsheet gurus?

[figner]

Don't forget to take state taxes into account if applicable. For instance in California, add another 9% state tax on cap gains if you're in the top bracket (not hard to reach at $43k). Paying 24% tax now vs. some unknown amount later (especially if you might consider moving to a lower-tax state) doesn't sound so good to me.

[packrat44]

Originally Posted by bots2019

It took me awhile and several calculation in excel to completely get JohnEyles' point, but I think he's right on. The absolute values don't matter (whether it's 400K or 4K), the holding period is what determines whether taking action is 'worth it'.

For example, if you've got $400K in capital gains, you'll have to pay 60K now to avoid paying 80K later (assuming a future CG rate of 20%). If 'later' means two years from now, you've earned an effective annual rate of over 15%; however, if 'later' is 25 years from now you're earning less than 1.2%.

This clearly isn't a open and shut issue - if you're looking at a projected holding period of 10 years, the guaranteed (after tax) return of 7.2% is quite attractive. If you're not going to take the gains now then you'd better plan on holding them for awhile to make it a good decision.

I have not run a spreadsheet to see how it plays out.

However, I have other issues that will dictate the sale of the individual stocks in 2010. Want to get out of individual stocks and place in index funds; fund a CD or bond ladder for 5 years; build up the MM account; fund the remainder of a multi-year ROTH conversion; and with some funding used for spending until start drawing SS in 2014. Have not sold much to date because it would put me over the $100K limit and negate my doing the ROTH conversion. If you are going to sell soon anyway, I might as well sell at the 15% tax rate rather than at the 20% rate.

Will run a spreadsheet to see what works best for the MFs that are in the taxable side of the account.

[chinaco]

Originally Posted by JohnEyles

...
Let's say I'm thinking of reseting a position that's worth $125K,
of which $25K is capital gain. (I'm assuming the gains are all
long-term, and that I'll pay the taxes with other money,
reinvesting all $125K). Conventional wisdom might say
"of course it's a good idea to do this, capital gains tax will
very likely be higher down the road". But this is different
than the Roth conversion decision, because "down the road" I
will STILL have to pay cap-gains tax on the additional gains
(above the reset basis of $125K). So the $25K * 15% tax
I might pay today, is an investment whose return is only
$25K * X%, where X% is the future cap-gains taxrate. So,
if I cash in the posion 25 years from now, even if the
cap-gains tax has increased to 30%, my ROI on that money
(with which I paid the tax) is only about 3% (annualized).

...

Maybe I missed something here, or in later discussion comments... But Traditional IRAs will be taxed as income not capital gains.

The tax differential question related to tax deferred accounts is usually around income tax rates not investment related tax rates.

Typically people use tax deferred methods to keep their current taxable income level down and defer taxes. For example contributions to a 401k might reduce your tax rate today. Plus, if your income level is lower when you retire, you will pay income tax at a lower rate than you would today.


To me, rolling money to a Roth makes a lot of sense... but as always, it depends on your situation. As far as tax laws go... You do not have much to go on. But I believe that the way the Roth works will not be disturbed. Why? Because, the government keeps a bit of a lid on how much money most people can put in those types of accounts. I do not believe they will go back on that rule. However, they may do away with it and grandfather accounts may be all that are allowed.

If you are really worried about the Roth changing you can hedge the bet by splitting the difference... 1/2 Roth and 1/2 traditional Tax Deferred.

[dmpi]

Originally Posted by LOL!

I prefer to die and my heirs will not pay any capital gains taxes since step-up basis is tax-free.

Me too. But I got 40+ years (I hope). You have to pick your investments very carefully to survive 40 years. I use ETFs like SPY.

Also if I need money, I can always open a margin account and start pulling money out without selling the stock.

[JohnEyles]

Chinaco, I think you completely missed the point of my post,
which is that the "pay tax now versus pay tax later" decision is
completely different in a taxable account.

And packrat, yes by all means, if you think you want to sell a
position soon, by all means do it while the cap-gains taxrates are
low like they are now. The mathematics is really quite simple -
no spreadsheet need apply. You can compute the rate of return
on the money you might (or might not) use to pay tax on a "basis
reset" as: the Nth-root of X/15, where X is the predicted cap-gains
tax-rate when you plan to liquidate the investment N years from now.
(Of course, you need to subtract 1 from that Nth-root and mulitply by
100, to get an annualized percentage).