Would you like to save 25 percent on your taxes? If you have a stock that has gone way up in value, you may have the opportunity to save that much in 2012.
When you buy a stock, you are hoping that its price will go up and you will be able to sell it later at a tidy profit. The difference between the purchase price of the stock and its sale price is called the "capital gain" (or loss, if it went down instead). The capital gains tax rate is different from the tax on wages or interest. If you have owned the stock for more than a year, you would pay the "long term" capital gains tax rate, which is capped at 15 percent. Taxes on wages can go as high as 35 percent.
It's important to keep in mind that the money you get to keep from the sale will be reduced by 15 percent of the portion that is capital gains. In a sense, a portion of the gains in your portfolio aren't yours at all; they belong to the government. Remember, it doesn't matter what you have -- it matters what you get to keep. I tell my clients to visualize their portfolios with this in mind, like a pie chart with a healthy slice going to the government. We always want to be on the lookout for ways to reduce the size of the piece that goes to the government. This blog highlights one way to make that happen.
Many people have stock portfolios with large capital gains: Stocks bought long ago and held for a long time; stocks inherited from family years ago and neglected, or maybe you made a terrific pick and the stock has gone way up in value. Today, 15 percent of that gain belongs to the government. The trouble is, on Jan.1, 2013, the current tax rate is due to expire and the tax on those gains will go up to 20 percent. So if you were to sell the stock next year, you would pay more tax on the gain.
So how can you avoid this? One sure way is sell the stock this year and pay the lower tax rate. If you really like the stock and want to keep it, there's nothing preventing you from taking the money and buying the same stock right back again. Yes, after tax you would only be able to buy less of the stock than you had originally, but remember, that 15 percent of the gains belonged to the government anyway. Better to sell it now and keep 85 percent than to sell it later and keep only 80 percent. The point is to maximize what you get to keep. Sometimes that means paying taxes now when they are lower, "on sale," if you will. Future gains on the newly repurchased stock will be taxed at the new 20 percent rate, but you will have locked in the lower 15 percent tax rate on all previous gains.
You may have heard of the "wash sale" rule that says if you sell a stock, you must wait 30 days before buying that same stock back, but that rule only applies when selling a stock that has fallen in value and a capital loss has been taken. A loss like this will cancel out capital gains and help you reduce your taxes. There is no such restriction when you sell stock for a gain.
There are some cases where this strategy should not be used. Many stocks are purchased to provide income now from the dividends the stocks pay, rather than to be sold later for a capital gain. These are often stocks like utility companies. Even if you have gains in these stocks, you may not want to sell them because if you lose 15 percent of those gains to taxes, you will also reduce the income they will provide. It might be better to keep the stock and enjoy the higher income. You also don't want to sell them if you expect to die before you sell them, because when you die you will pass all the stocks on to your heirs with no capital gains tax (this is called a "stepped up basis"). And, none of this applies to stocks held in an IRA, 401(k), SEP, or other "qualified" plans where everything is taxable at the same rate you pay on ordinary income, no matter what.
It is true that Congress may extend the lower rates for another year, in which case you could wait. It's very hard to predict what will happen at the end of an election year. Even so, it is unlikely taxes will be lower in the future, so you may just decide to play it safe and sell now. Either way, you want to be prepared. When you next meet with your stockbroker or financial adviser, ask them to determine what stocks in your portfolio may qualify. Double check it with your accountant. That way, if it makes sense to take advantage of this tax sale, even if you wait to see what Congress does in December you will be ready. Remember, it's not what you make -- it's what you keep. Sometimes it is better to pay some taxes now to save even more taxes later.
In a future blog, we will look at how half the population may be eligible to sell some of their stocks now and pay no capital gains.