The contentious fiscal cliff negotiations in Washington have drawn a lot of attention to taxes; specifically, to the possibility that tax rates on income, capital gains and qualified dividends will go up for many of us, beginning January 1.  If there is no tax deal and the automatic increases kick in, people in the 33% tax bracket will find themselves paying taxes at a 36% rate, and those paying at the 35% rate currently would jump up to the 39.6% tax bracket.  Capital gains rates, meanwhile, would rise to 20%–plus the 3.8% Medicare tax on investment income for people earning more than $250,000, which actually only applies to amounts over $250,000 in that year.

Some commentators are suggesting that, faced with higher taxes, investors should turn normal tax planning on its head.  Instead of harvesting losses in the portfolio to create deductions (and a lower tax bill) in tax year 2012, why not harvest gains at today’s low 15% (for most of us) or 0% (for some of us) capital gains rates, and pay MORE in taxes?  That way, you would reset the cost basis of the investment up to its sales price, so that the gains would be lower when the investment is sold in the future.  Future higher tax rates would be applied to that lesser amount.

Interestingly, there is no wash-sale rule to worry about when you harvest gains.  When you sell at a loss, the IRS requires you to wait 30 days before you can buy the same (or a similar) security.  When you sell a security that has gained in value, you can buy that investment position back immediately.

For example, suppose that you own stock that is currently worth exactly $30,000, and you paid exactly $20,000 for it more than a year ago.  Between now and December 31, you sell the stock and then buy it back again immediately at the same price.  Capital gains taxes on that $10,000 gain come to $1,500–rather than the $2,000 you would have had to pay if you had sold the same stock at the same price in January.  You saved $500, right?

If you plan to sell the stock in January, and you know for sure that capital gains taxes are going to rise once Congress finishes posturing, then this is a terrific tax-savings strategy.  But what if you were planning to hold onto the stock?  What if taxes on capital gains stay at their current levels?

Let’s look at some of the possibilities.  If the current law expires and no tax deal is reached in Washington, then capital gains rates would rise to 20%–except for investments acquired after 2001 and held for at least five years, which would qualify for a special 18% rate.  If you have more than $250,000 in yearly income, you might find yourself paying at a 23.8% rate once the Medicare tax is calculated in.  And there is a small chance that Congress will decide to do away with the capital gains exclusion altogether, and at the same time raise ordinary income rates back to their former 39.6%.

How long would you have to hold your investment before you’d come out ahead by NOT harvesting gains this year? It depends on the average return on your investment, and also on the future tax rate.  The table below offers some scenarios. If capital gains rates go up to 20%, and you achieve an average 7% annual rate of return, then if you hold the investment for five years or more before selling and paying your taxes, your best choice would be to hold for the future.  If you plan to sell before that, then taking gains now is your best option.

At the extremes, if you believe that returns will be dramatically lower than 7%, or if you believe that the 39.6% rate will apply to your future capital gains, you’ll probably be better off having harvested gains today.  At the other (not so extreme) side of the debate, if Congress decides to keep capital gains where they are, then harvesting gains will have increased your 2012 tax bill for no good reason.  And if you hold the stock without selling for the rest of your life, then your heirs would receive it at a stepped-up cost basis–the accounting world’s fancy way of saying that all the gains you earned during your lifetime would never be taxed.

Of course, this exercise doesn’t take into account state taxes or AMT calculations, both of which can make the numbers vastly more complicated without greatly changing the conclusions.  Nor does it take into account the trading costs involved in selling investments and then buying them back again.  Over the next few weeks, we may get a bit more clarity on how investments will be taxed in 2013 and beyond.

Deciding to harvest either gains or losses is unique to your circumstances.  We look comprehensively at your tax situation to determine what course of action is warranted, bearing in mind the tax drag on rates of return.  Electing to harvest gains and pay the associated taxes now is an irrevocable decision.  We take the time to analysis and thoroughly understand the consequences of making this type of decision.  We appreciate the continued trust you place in us to offer this type of guidance.