The traditional aim of tax planning is to do everything legally possible to reduce current taxes. One common approach is to defer realizing capital gains for as long as possible. Tax deferral, like the miracle of compound interest, is often seen as a "no brainer," an idea that always makes sense. After all, it's like getting a free loan from the government, and is particularly valuable if the client's investment horizon is long and the return on the investment is high. Rarely, if ever, do we consider actually paying taxes early as a benefit in our tax planning strategy.
But under JGTRRA, the 2003 tax legislation, long-term capital gains tax rates are at their lowest level since 1942, and they are scheduled to revert to their former higher rates in less than four years (See Rates Now table below). Additionally, the growing federal budget deficit, increasing budget demands, and the 2004 presidential elections may catalyze a tax increase even sooner. If we expect capital gains rates to rise, we should ask this question on behalf of our clients: Should we take advantage of the current low rates and realize appreciated capital gains now, or should we instead defer taxation and pay at a future higher rate?
The answer depends on a number of factors and will vary for individual clients, including the expected future tax rate, the client's investing time horizon, the anticipated investment return, and the client's overall risk tolerance. It is often possible as well to improve on the pure tax-deferral strategy in a rising-tax-rate environment, which we appear to be in.
While we do not wish to engage in a detailed discussion of the likelihood of a capital gains rate increase, we can provide background perspective and judgment as to when it makes sense to pay taxes sooner rather than later.
Anticipating Change
A review of federal capital gains tax rates reveals that there have been 13 rate revisions since 1942. If one includes changes to the way "long term" is defined, there have been 16 changes. This may not seem like many changes over 62 years, but most have come since 1970, and the recent average period between changes is less than three years. The "Top of the Charts" table below displays the top rate each year.
It is my opinion that current tax rates are as low as they are likely to be in the near-term future. Whether one uses inside information, thoughtful analysis, or political argument, a change in tax rates can be expected, even though the timing and magnitude are uncertain. Few investment advisors forecast or predict future tax rates, but doing so can be a rewarding financial endeavor. Certainly, tax rate changes occur more slowly and with more public discussion and debate than interest rate changes, for example. Unlike other financial market predictions, prices do not imbed consensus estimates of capital gain taxes, and the benefits of prediction are not arbitraged away by other market participants. A prediction, though uncertain, is often a better choice than the easy assumption that rates will remain static.
The Advisor's Contribution
Even though future tax rates are unclear, it is possible to provide a decision-making framework for evaluating a tax strategy of paying taxes now rather than later. The central issue is this: Should we give up on the value of tax deferral in order to derive a larger future benefit? This requires a tradeoff between the value of the deferral and the benefit. The value of the deferral is affected by the investment horizon, the expected future return, and the expected future tax rate, and so these influence the decision.
The following is a simple model to integrate the key issues. We ask: Given an expected return on investment and a liquidation horizon, by how much do tax rates need to increase in order for an investor to prefer to liquidate and pay taxes on gains now? Our analysis solves for this number, which we call the "Liquidation Tax Hurdle."
