If Taxes Were Going Up

The Wall Street Journal has been running a series modestly entitled "The New Rules of Personal Finance". The most recent installment is on what to do differently now that you know that taxes will be going up.1040

As readers of this blog know, I’m not all that convinced taxes are on the way up anytime soon. Yes, the deficit and debt are heart-poundingly frighteningly large. And yes, any reasonable observer can see that something has to be done. That doesn’t mean it will be.

I am sure that the Administration and its supporters would, if they had their druthers, raise taxes significantly to get the deficit under control. But I am also sure they are aware enough to see that they just don’t have the political capital right now. And when would they? Next year, during the mid-term election season? In 2011 and 2012, when Obama will be facing what is looking like a tough reelection?

It seems to me that the earliest a tax increase large enough to worry about could arrive would be 2013. Of course, I would be the first person to concede that handicapping what will happen in Washington is nearly hopeless.

So, speaking strictly hypothetically, what should you do about rising tax rates? As far as normal day-to-day stuff goes, probably not very much. On the assumption that taxes will "only" go up by 5-10%, it seems rather unlikely that it would make sense to change how you live significantly by, for example, changing jobs or working more or fewer hours. You will may notice that you are poorer, and will spend and save a less as a result, but there won’t be a lot you can or should do about it.

The WSJ piece says that the impending tax increase "turns traditional tax-planning logic upside-down." There is some truth to that, but let’s not exaggerate the practical effects. A tenet of tax planning common sense has been that if you have the choice between paying Uncle Sam a dollar sooner or later, choose later. So if your company offers to pay your end-of-year bonus either in December or January, you should pick January because it will put off the day you need to pay taxes on it for a year.

The upside-down part comes in if you know that income tax rates will rise on January 1. In that case, you are better off getting the bonus in December. Similarly, if you are withdrawing from a traditional IRA you would be better off taking out money (and incurring taxable income) before the rates went up.

But for most folks, most of the time, the opportunities for changing the timing of income are pretty limited. That is less true of capital gains and losses, where the investor usually gets to choose what day to realize the gain/loss and therefore in which tax year to pay taxes on it.

If you are thinking of selling some stock that you have a gain in, and you know the capital gains tax rate is going up, it would make sense to sell sooner rather than later. But with capital gains there are some other factors to consider. First, the rates for short-term gains (on investments held less than a year) are generally higher than for long-term gains. It is very likely that even if rates were going up, you’d still be better off waiting until your short-termers mature into long-termers.

And for long-term holdings, the capital gains tax you owe is something like an interest-free loan from the government. If you bought a stock at $100 and now, several years later, it’s worth $200, then you are in a sense carrying a $15 debt to the taxman. (Assuming a 15% rate on your gain of $100.) But you don’t have to pay the $15 until you sell, and in the meantime you get the benefits of owning $15 worth of stock in the form of dividends and appreciation.

The WSJ article suggests that readers might want to engage in a sort of upside-down wash sale if they have stock with long-term gains. Selling and then immediately buying back stock to realize a loss is called a wash sale and doesn’t count for tax purposes. But doing it to realize a gain and pay more in taxes this year is, graciously, allowed by Uncle Sam.

I’m sure this maneuver has its place, but it seems like a generally poor strategy to me. Apart from my skepticism about the near term prospects for rate increases and the loss of the interest-free loan discussed above, there is the issue of what happens if the stock then goes down.

If you sell and then buy back the stock at $200, incurring $15 in taxes this year, and then next year you sell the stock for $100, you won’t be able to use the loss next year to claw back the taxes you paid this year on your now evaporated gains. Instead, you have to carry the $100 loss until you have gains to offset it, which could take a while.

Many of us have basically this problem, capital losses from 2008 on previously taxed gains that we are waiting patiently to use. A little bizarrely, the WSJ piece suggests that the upside-down wash sale makes particular sense for us.

This strategy makes even more sense for those with unused capital losses from the past year’s market maelstrom, because such losses can be used dollar-for-dollar to offset long-term gains.

Huh? Just about the only nice thing about having a loss carry forward is that if the tax rate goes up in the future you can use it to shield yourself from paying more taxes. If you have a $100 loss you are carrying and the capital gains tax rate is 15%, you’ve got got a get-out-jail-free card worth $15. If the rate increases to 20%, it’s worth $20. So if you thought rates were going up, why would you engineer a situation to use up your losses now?

Perhaps the best argument against taking action now based on the "reality" of looming tax increases is that the nature of those tax increases is unknown. No law says that it would be limited to an adjustment of rates. The rules could change or entirely new taxes could be introduced. Any trick that sounds clever today is liable to seem foolish in a new tax landscape. Which is another good reason to sit tight and watch what, if anything, develops.

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