When to pay capital gains for greater diversification

[bamsphd]

I will soon receive in kind with no step up in cost basis
the shares of 37 different companies.  These shares have
mostly been held for decades, and almost all of the tax
losses have been harvested.  My tax basis will mostly
be between  50% and 1% of the current market value.

While the companies have not been bad investments,
(the portfolio manager harvested all the mistakes) I would
prefer wider diversification, both in the sense of more
stocks through Vanguard index funds, and in the sense
of more asset classes.

What I don't know is what algorithms to use when deciding
how to value the cost of incurring capital gains taxes now,
versus the benefit of better diversification.  Can anyone point
me to any articles or discussions on this topic?

thanks,
Bill

 

[Craig]

First thing I would do is find and consult with a sharp tax CPA and / or attorney ... I'm biased towards the CPA. Make sure this is your only tax planning alternative (though I'm 80% sure it is ...).

 

[nfs]

The first question I would ask is, "How big a portion of your net worth is this account?" If it's small, then I think you just flip a coin, because it's a tossup between small tax costs for liquidation and small loss risk if the account is not well diversified.

If it's a big fraction of your net worth, then there's a second question to ask. "With 37 stocks in the account, how different is this from the S&P 500 (to pick an index)?" If the correlation is really high - and it could easily be >0.9 with that many stocks - then VFINX buys you almost nothing in risk reduction for the tax you would prepay. Other asset classes help more, of course, if you're willing to use them.

Here's yet another question. "Got any loser stocks elsewhere in your portfolio?" You can use them to offset gains on liquidation.

And another. "Do you really need the money in the first place? If not, donating low cost basis shares gets you a big tax deduction."

... "Short life expectancy? Maybe your heirs can get a stepped up basis on your death."

Last but not least... "The capital gains tax is only 15% now, the lowest it's been in 50 years. Maybe I should just pay it now because the rate will be higher if I wait?"

 

[ESRBob]

To pick up on NFS's point -- don't diversify from this into a US stock index fund, but you may well feel you need to diversify from this basket of stocks into other asset classes altogether. I doubt you'll find an algorithm that could tell you anything meaningful -- there are too many variables and probabilities in relative performance of asset classes in future, tax rates, etc. I think at some point you just decide you buy the slicers modern portfolio theory asset allocation approach or you don't. If you buy it, then you take your medicine now in the form of some realized capgains, trying to minimize them as much as possible.

One thing you might bear in mind if you are close to ER: your tax bracket could drop as your income drops in ER, which could make you eligible for the special 5% LTCG rate (if your fed bracket is the 10% or 15% bracket). That seems well worth paying for the diversification benefits.

 

[whitestick]

(One thing you might bear in mind if you are close to ER: your tax bracket could drop as your income drops in ER, which could make you eligible for the special 5% LTCG rate (if your fed bracket is the 10% or 15% bracket). That seems well worth paying for the diversification benefits.)

When you cash in sufficiently large amounts of these capital gains, does that then push you into the higher tax bracket, or does cap gains only get determined on the "other" income that or AGI that you have? If not, then the time frame to fully sell and pay the cap gains at the lower rate might extend beyond the current limits of the reduction, and the cap gain rate will go back to the higher level.

 

[Nords]

When you cash in sufficiently large amounts of these capital gains, does that then push you into the higher tax bracket, or does cap gains only get determined on the "other" income that or AGI that you have?  If not, then the time frame to fully sell and pay the cap gains at the lower rate might extend beyond the current limits of the reduction, and the cap gain rate will go back to the higher level.

Nah. Two methods are used to calculate the tax due and you get to use the one that produces the lower number.

First you pile up all the "income" and calculate the tax. That's a big number because it blows right through all the lower tax brackets to 25% and perhaps even beyond.

Second you set aside all the cap gains. You calculate the tax on the remaining income, whatever bracket you end up in. Then the cap gains are taxed at whatever cap gains rate is appropriate for the bracket of the rest of your income. That tax total is usually a lot smaller because the highest rate never exceeds 15%.

The theory sounds complicated when it's explained, but when the calculations are chugged through (or done with TurboTax or by an accountant) the execution is straightforward.

 

[lazyday]

Then the cap gains are taxed at whatever cap gains rate is appropriate for the bracket of the rest of your income.

Are you saying that if your income is low, you can take as much 5% cap gains as you like? If so, I've made some bad decisions the last few years, and this year I'll probably sell almost everything I own that isn't in an IRA, to lock in the 5%.

 

[Nords]

Are you saying that if your income is low, you can take as much 5% cap gains as you like?

That's exactly what I'm saying.

Take a look at page 22 of IRS Pub 505 (Estimated taxes):  "Tax on net capital gain.  The regular income tax rates for individuals do not apply to a net capital gain.  Instead, your net capital gain is taxed at a lower maximum rate.  The term 'net capital gain' means the amount by which your net long-term capital gain for the year is more than your net short-term capital loss.
"Qualified dividends.  The maximum tax rate for qualified dividends is 15% (generally, 5% for people whose other income is taxed at the 10% or 15% rate).
"If you expect to have a net capital gain or qualified dividends, then use Worksheet 2.5 to figure your tax."

I plug through that $%^*ing worksheet every year.  Although worksheet 2.5 is far from intuitive, it splits your cap gains out from your income and taxes the gains at the 5% rate if your other income is taxed at the 15% rate or less.  There's some fuss about "unrecaptured section 1250 gain" and "28% rate gain or loss" that you have to know for collectibles, rental real estate, and presumably another arcane loophole or two, but for most of us those phrases do not apply. You can look at your fund gains, decide how much your cap gain on the sales will be, determine your net cap gains, and start plugging numbers into worksheet 2.5. Give yourself a quiet, well-lit room, a couple hours of uninterrupted time, a sharp-tip pencil with several extra erasers, a magnifying glass, and a BIG cup of hot coffee before you start.

So if your 2005 married joint income is below $59,400 and you have $1M stock or mutual-fund cap gains above & beyond your income, then the tax on that $1M cap gain would be $50,000 (in addition to the tax on your income).  Stock/fund cap gains are not the same as real estate or collectible cap gains, and I'm sure there's some other obscure cap gains categories as well.

Presumably Form 1040 calculates your tax using the same method but that's a much bigger document to search through for the worksheet.  (Maybe someone else here has the link at their fingertips.)  I don't know exactly how it's handled on Form 1040 because TurboTax never discusses it with me.

If you've been paying someone to do your taxes, perhaps you two need to have a little discussion about revised tax returns for prior years. If you're right and they're wrong, then I'm sure they'd be happy to atone for their mistake by doing the paperwork for free.

This is just one of many ways that ER taxes are much lower than taxes during your working years.  Another niche ER tax trick is to convert conventional IRAs to Roth IRAs during those pre-SS, pre-RMD years when your taxable income is low.  Dory mentions a little about this in the FIRECalc FAQs and Bob Clyatt goes into more detail in "Work Less, Live More".

 

[nfs]

That's exactly what I'm saying.

It works as Nords suggests, if it weren't for AMT.

So if your 2005 married joint income is below $59,400 and you have $1M stock or mutual-fund cap gains above & beyond your income, then the tax on that $1M cap gain would be $50,000 (in addition to the tax on your income).

Except for AMT.

 

[Martha]

It works as Nords suggests, if it weren't for AMT.

But, even if you are hit with AMT on your ordinary income, I believe you still get the 5% rate on your long term gains. If I recall, Congress had to amend the law a year or so ago so that low ordinary income earners who ended up paying AMT did not lose their 5% rate.

 

[whitestick]

Wow!, I agree with LazyDay. Only final problem, that I have is to see if I can get my employer to hold all my wages for 1 year and not pay them to me, so I can convert all my cap gains at the 5% rate, and then go back the following year to get both years worth of wages. Unfortunately, I'm right on the cusp of retiring - spring of 2009, and the cap gains rate is due to expire in 2008. Not believing that GW will be successful in extending the lower rate, I will pay high penalties, relatively so, for not being able to cash in at that 5% rate.
Thanks for the info though, now I have to go back and refigure, and see if maybe it would be worth it to retire a year and 1/4 earlier, to get the lower rate. Of course that impacts the pension, SS, and all the rest. Or maybe not - Does this seperation treatment apply to SS as well, such that the redemption of the higher dollars due to cap gains, both short and long term, and dividends, does not apply to adding to SS to push into the higher tax bracket for the combined income.

 

[ESRBob]

Just so we're clear -- the 5% rate doesn't apply to converting a traditional IRA or 401k to a Roth, but only to realizing capital gains on normal taxable investments.

The conversion of another IRA to a Roth involves realizing the entire converted amount as ordinary income that year, paying at ordinary income tax rates.

It is one of the reasons I've always been so keen to convert to Roths: IRA money, especially as it balloons into sizable appreciation over the years, comes out at ordinary income rates, with a required minimum distribution (RMD) to force it out even if you'd rather not. It all sounded good when you put the $ into a regular IRA, but every year it grows in there you're just delaying the inevitable. Load up a SEP etc. to the full extent you can, of course, but then plot how you're going to get the money out into a Roth before you're a senior citizen. This

The "realize gains at 5% in your early years in ER" gambit (or if you can get your boss to suspend your salary for a whole year? ) is ideal for moving from a non-diversified asset allocation to something more diversified which will stand you in good stead for the long run. Once you've done that, you can let gains accrue, deferred and unrealized, until you die, only paying tax on the bits you need to sell during rebalancing, or for spending money over and above interest/dividend income that year.

With 2008 looming, and the fate of the 5% capgains (and qualified dividends) bracket in doubt, these could be the years to make those major portfolio restructurings. It may seem like painful medicine to pay any tax before you have to, but I still think in this case it's worth it.

 

[lazyday]

Holy smoke
Fantastic news.

Thanks so much Nords for bringing this to my attention, and for your detailed response. And to others for responding as well. This is the second time since I've been on these forums, where my finances are improved because of the people here.

I've been doing yearly conversions from IRA to Roth each year since I stopped working, to max out the 10% bracket and get partway to the max of 15% bracket. Was (incorrectly) using LT cap gains at 5% to get the rest of the way to max out the 15% bracket. And, not selling all of what I wanted to sell, since I thought I'd pay 15% tax past the "limit."

My situation is relatively simple, as I own no home or other real estate, and all my income is from mutual funds/stock and the conversion to Roth. Cap gains are all from sale of mutual funds/stock, and distributions.

I've never hired anyone to help with taxes, so it's all my fault.

Now I have some work to do, planning some big (for me) sales this year, a larger Roth conversion than I expected (thanks again Nords), and a little beating myself up for not figuring this out when the 5% rate first came into being. But, it means more money in my Roth, which should eventually mean more money in my pocket!

I'm really surprised the taxes work this way. It's like a loophole, though may be difficult for a very wealthy person to use even without income one year, as their dividends&interest may put them over the 15% bracket. So, a loophole for the middle class! (who can avoid regular income for a year)

Also surprised nobody ever corrected me, as I've made posts before which implied that you pay 15% on the LT gains past the amount which brings you to the end of the 15% income bracket.

 

[Martha]

Whoa everybody. I am not sure that the analysis is correct. Say a couple has $20,000 of ordinary income and $500,000 of long term gains. It may be that of those long term gains only up to roughly 39,400 ($59,400-20,000) is taxable at 5% and the remaining at 15%.

Will report back later.

 

[Danny]

Holy smoke
Fantastic news.

Thanks so much Nords for bringing this to my attention, and for your detailed response. And to others for responding as well. This is the second time since I've been on these forums, where my finances are improved because of the people here.

Also surprised nobody ever corrected me, as I've made posts before which implied that you pay 15% on the LT gains past the amount which brings you to the end of the 15% income bracket.

I'm pretty sure you pay 15% capital gains once you pass over the end of the 15% income bracket, even if it is capital gains that pushs you over.

 

[Martha]

DanTien, I think you are right. I just went through the estimated tax worksheet and it seems to work that way. You only pay the 5% on the amount which would take you up to the top of the 15% bracket.

Sorry guys, no loophole.

 

[Danny]

CCH is a good resource for tax questions.

Here's a quick and dirty tax calculator for 2005.


http://www.finance.cch.com/sohoApplets/Tax1040.asp

 

[Martha]

CCH is a good resource for tax questions.

Here's a quick and dirty tax calculator for 2005.


http://www.finance.cch.com/sohoApplets/Tax1040.asp

Hey, same calculator as on the dinkytown site. http://www.dinkytown.net/java/Tax1040.html

These two calculators don't do AMT.

 

[Danny]

Hey, same calculator as on the dinkytown site. http://www.dinkytown.net/java/Tax1040.html

These two calculators don't do AMT.

Yeah!
At first I started to believe I'd been doing it wrong the last few years and I was preparing to refile to get some dough back , but your questioning post brought me to my senses. Now, I'm worried for Nords.

 

[lazyday]

Well, I had planned on making my own spreadsheet of the IRS page Nords linked to, and/or re-installing 2004 TurboTax to check that there's no limit on 5% LT gains.

Had trouble getting IRS worksheet 2.5 to work using realistic numbers, but simply using 0 income and 100K or 1M LT gains, it shows the 15% rate, by my work.

I tried DanTien's link (online calculater) and put in 0 or 10K income, $1M LT gains, and tax came to about $150K, or 15%. 100K gains has similar results, not quite 15% because of deductions, exemptions, and the lower brackets.

 

[ladelfina]

This is a great topic. I got to you guys after looking into some sites about Retirement Investing and ETFs.. I have put some of my (then-too-big) cash cushion into Gov. bond ETFs and a small-cap ETF to round things out, but am unsure about whether to sell some big performers like TMX/AMX.. I mean, my income is low so I can groove with the 5% CG but still.. 5% is 5%. I don't need to sell for income now.

OTOH, if I'm looking at a 100k gain, the difference between 5k and 15k of CG is not insignificant...

I'm asking myself whether the diversification into a strictly structured ETF plan is worth that extra 5% off the top, if everything else is considered equal.. Strangely, the sites promoting ETF theory say "sell all your stock" without even mentioning the CG issue.. maybe they are focusing on IRA assets?

In a very general way, the stocks I have now are relatively diversified; they just aren't as fully-diversified as an ETF plan would be...

Still unsure what to do as someone who is not an investment junkie or tax maven. I like watching the stocks in my taxable account go up.. but what goes up must come down (or out!). Am I too emotionally wedded to a winning stock to do the rational thing?

 

[Nords]

Now, I'm worried for Nords. 

Well, clearly I'm better at plugging through worksheets than I am at understanding their theory. Thanks for pointing out my "conceptual error", Martha, and I apologize if I got anyone else salivating about something that turned to be too good to be true. Luckily I didn't have to understand what I was doing to plug through the worksheet and put the numbers into TurboTax. They calculated the results correctly even through I was blissfully ignorant.

Getting back to Whitestick's original point:
- At a time in our lives when spouse & I have very low earned income, I wouldn't hesitate to take huge cap gains to reallocate a portfolio. I'd be even more motivated to do so if I could pay cap gains tax (at 5% & 15%) instead of paying full earned-income tax rates on RMDs.
- If I ended up holding an undiversified hairball of stocks, I'd have two choices:
-- spend my time getting to know them as intimately as Warren Buffett, and spend a considerable portion of my life managing them, or
-- immediately diversify risk for which I am not being adequately compensated.