Ignoring Taxes Can Be Detrimental to Your Wealth
A deferral a day keeps the tax man at bay. What is the real value of tax deferral on capital gains? Minimizing taxes is a key part of any comprehensive wealth management plan. With the complexity of the tax code, it is almost impossible for a working professional to keep abreast of the best tax strategy in any given year. For that matter, the best way to guarantee a good retirement is to focus on your career. A simple rule of thumb that most professionals use is to defer taxes as long as possible. In the face of a rising deficit and national debt, that may not be the best strategy. Deferring taxes may not be as helpful as you think.

Let’s assume you have a stock currently worth $100,000 and you originally paid $20,000 for your well timed purchase in 2009. You owe the Federal government $12,000. Luckily, this is an interest free loan that can be deferred as long as you own the asset. In fact, they are a partner with you as they will share in your gains and losses.

 

Current Year

Appreciated Stock Value

 $        100,000

Cost Basis

 $          20,000

Net Gain

 $          80,000

Tax at 15%

 $          12,000

After-Tax Value

 $          88,000

 

The most important point to remember is you do not have $100,000. You cannot spend $100,000 and pay for it with this stock. Ignoring transaction costs, you can only spend $88,000. You have two options, defer the taxes and continue to hold the stock or sell it and reinvest in another position. Assuming that you make 7 percent on either investment and capital gains tax rates remain 15 percent, your investment position in one year will look like this:

 

Defer Tax

Sell Now and Invest Proceeds

New Investment Value

 $        107,000

New Investment Value

 $          94,160

New Cost Basis

 $          20,000

New Cost Basis

 $          88,000

Net Gain

 $          87,000

Net Gain

 $            6,160

Tax at 15%

 $          13,050

Tax at 15%

 $                924

After tax Value

 $          93,950

After tax Value

 $          93,236

 

Notice the increase in wealth from deferring taxes is $714 or 0.7 percent, not a large amount when considering the size of the position. In fact, I would say taxes are much less relevant than determining whether you wish to continue to hold this stock or replace it with something else. A good way to look at this situation is to rephrase the question: Would you buy $100,000 of the stock today? If not, why are you continuing to hold? Transaction cost and tax savings are minimal. Many investors continue to hold a position because of the emotional capital they have invested in watching the company, or it could be fear of regret. Research shows that the regret of commission (taking an action) is stronger than the regret of omission (not taking an action), so many investors defer decisions to minimize regret. A key thing to note is not taking an action IS a decision.

The other risk you face by holding on to appreciated stock is that the Federal government has the ability to increase the tax you owe at any time. You are giving them that ability for 0.7 percent a year. In 2013, the Federal capital gains tax rate is set to increase to 20 percent. With the same two choices as above, your positions would change to this:

 

Defer Tax

Sell Now and Invest Proceeds

New Investment Value

 $        107,000

New Investment Value

 $          94,160

New Cost Basis

 $          20,000

New Cost Basis

 $          88,000

Net Gain

 $          87,000

Net Gain

 $            6,160

Tax at 20%

 $          17,400

Tax at 20%

 $            1,232

After tax Value

 $          89,600

After tax Value

 $          92,928

 

Instead of making $714 by deferring the tax, your net worth has actually decreased by $3,328. The odds are high that we will not see lower rates in the future and most likely will see higher rates, especially on the high wage earners. In fact, if capital gains taxes rise to 15.9 percent, the value of your deferral will disappear.

Families with incomes above $250,000 are most at risk and should definitely consult their financial advisor and accountant before year end. Congress passed a tax to help pay for the health care reform law that will increase income and investment tax by 3.8 percent in 2013. This tax looks likely to stick. The new tax alone would result in a deferral loss of $2,358 if the underlying capital gains tax stays at 15 percent and rises to $6,400 if rates go to 20 percent.

Tax rates are not likely to decrease, and the highest wage earners are most at risk. Paying more tax today could lead to more wealth in the long run. To optimize tax deferring benefits in a high tax rate environment, you will need to extend your holding period. The bottom line is deferring taxes and decision-making may be detrimental to your long term wealth.

 

Sean Barron is a portfolio manager at Delta Trust & Bank. He is a Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP) with a master’s degree in financial planning. To learn more, visit delta-trust.com.

 

 

 

 

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