No End of Year Tax Planning

Normally, this is the time of year that money advisors and gurus trot out the old canned advice on end-of-year tax planning. Not this year. This year we are all just too confused.

Generally, we can do little things in November and December to slightly lower our tax bill because, generally, we can predict what the tax rates will be in January. Not this time. Congress managed to adjourn for the elections without doing anything at all about the expiring Bush tax cuts, and when they Capitol reconvene for the lamest of lame duck sessions today I do not foresee a sudden clarity of purpose.

Could there have been any larger indication that the Democrats were in very serious trouble than that they passed up an opportunity to enact tax cuts a few weeks before an election? Yes, there were (and are) differences of opinion on what bits of the Bush cuts should be extended, but those differences ought to have been bridgeable. Instead, the Democrats became frozen in fear and indecision, petrified (and not entirely without reason) that any legislation they passed, whatever the particulars, would cost votes.

Now that the deer in the headlights has been squarely hit by what turned out to be a good sized truck, the situation is hardly any better. Say what you will about politicians pandering to voters, it does tend to get them all on the same page. With 93 members of the house packing up their offices and the other 342 not having to face voters for another two years, this is when principles become more important. And principle is the enemy of consensus.

There are no guarantees, but my money is on nothing much coming out of what is left of the 111th Congress. Both sides of the aisle will be quite happy to pass the whole mess off to the 112th in January. Sure, it would be nice if the citizenry knew, as the new year began, what tax rate they were then paying, but you can’t have everything. The cuts can be extended retroactively. Or not.

Most of the discussion of expiring tax cuts has focused on income taxes, but there is actually a vast array of tax law provisions that go poof at the end of 2010, including such things as R&D tax credits, the treatment of stock dividends, who is eligible to pay the dreaded AMT, and the repeal of the ever controversial estate tax. But with regard to the end-of-year tax planning we cannot do, it is mostly just the tax rates on two things, income and capital gains that we care about.

Income Taxes

In a typical year, when income tax rates are not changing, the general rule is that you want to put off income into next year and accelerate deductions into the current one. So, for example, you might pay your January mortgage and property tax bills at the end of December. Or, if you were lucky enough to be given the choice, you might elect to get a year-end bonus in January.

This sort of thing may not reduce what you will eventually pay to the government, but it will put it off for another year. And that’s nice. Think of it as an interest free loan.

However, it is a terrible idea if your income tax rates are going up. If you are paying 25% this year and will pay 28% next year, then you want to take all the income you can now, when it is taxed at a lower rate, and put off all the deductions you can until January, when they are more valuable.

And if you do not know if your rates are going up or not? Good luck. The most useful thing I can say is that the cost of being wrong if you assume rates will stay the same (shifting income into 2011 only to pay a higher rate on it) is bigger than being wrong that they will go up (shifting income into 2010 and passing up an interest-free loan.)

Capital Gains

To begin with, just in case you are a complete beginner, there is a big tax difference between capital gains on short term (owned for less than a year) and long term (owned for more than a year) assets. Sell something you owned for less than a year and the gain is taxed as plain old income. Depending on your forecast of what will happen to income rates, you might want to hold on to those BP shares you bought over the summer until January or sell them now. See above.

Long term gains, on the other hand, are presently taxed at only 15%. (Actually, it is 5% if you are in the 10% or 15% income tax brackets, which for an individual ends at $34,000. Elitist that I am, I will ignore this.) If the Bush tax cuts expire this will go up to 20%.

The thing about capital gains is that taxpayers often have a great deal of control over the timing of taxable events, much more than they do over plain old income. You do not pay taxes as your assets appreciate over the years. You pay taxes only in the year in which you decide to sell.

Regardless of what happens with the Bush tax cuts, the first rule on timing your sales is to try and make your gains long term and your losses short term. If it is just about time to sell something you bought 11 months ago, and it is in the black, you might want to think seriously about holding on until the position’s first birthday, which will meaningfully reduce the tax you pay on the gain.

Conversely, if the 11-month-old is underwater, that is, if when you sell you will book a loss, you should think seriously about getting out while it is still a short termer. You can net your loss against short term gains, which means that it is effectively an income tax deduction. If you hold on longer, and wind up with a long term loss, you can net that against long term gains, but with the rates for those so much lower, it is not nearly as much fun.

After doing what they can with short vs. long term holdings, most investors next try to minimize the current year’s net realized gains. Again, this only makes sense when the tax rate is not going up. Usually, towards the end of the year stock investors sell their losers to realize losses but keep winners until January to avoid realizing gains. (I believe that this habit sometimes produces what is known as the January Effect, wherein beat-up stocks outperform at the very start of the year.)

When you have one of those special years in which you know that the long term capital gains rates are increasing, then you would want to take the opposite strategy. Sell your winners and hold on to your losers. Pay taxes now on your gains at the lower rate, but defer your losses until later, when they will shield you from the higher rates.

Is this one of those special years? Could be.

Then again, if you have, like I do, what amounts to a lifetime supply of capital loss carry forwards from previous years, e.g. 2008, none of this matters much. Barring a shocking turn of events, it will be a few years until I pay capital gains taxes no matter what I do. Not something I’m proud of.

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