The $64,000 Retirement Question: Should We Sell Now to Avoid Higher Taxes Later?

The $64,000 Retirement Question: Should We Sell Assets Now to Avoid Higher Taxes Later?

by Bob Carlson, Investment U Research

A 2011 Investment U White Paper Report

It's still too early in the game to know, but the consensus is that in the future our taxes will be higher.

Given such prospects, an obvious question arises for many people in or near retirement - should we sell assets now (or take other steps) to avoid higher taxes later?

I don't have a simple "one size fits all" answer. But I can share the key factors you need to take into account before making this critical decision. First things first, we have some time...

When We'll See Higher Tax Rates...

Higher tax rates aren't coming until 2012, at the earliest. Policymakers may even hold off an extra year (or two) on any increases, given the severity of the Great Recession.

Realizing that uncertainty never fosters prudent decision-making; there's no need to rush a decision.

We're better served by waiting a few months until we have a good grasp of what the rules will look like.

Then, once those details emerge, we can consider strategically selling assets in an effort to minimize the effect of higher taxes. Here's my gameplan for doing exactly that...

Qualified Retirement Plan Accounts

For starters, consider taking distributions from:

  • 401(k)s,
  • IRAs,
  • Or any other qualified retirement plan.

Remember, distributions from these plans are taxed at ordinary income rates. So, by taking distributions early, you avoid higher ordinary income tax rates in the future.

What's more, if you reinvest the distributions in a taxable account, in assets you can hold for a long time - like solid, recession-resistant, dividend-paying stocks or bonds - your future gains will be taxed at the long-term capital gains rate, which is likely to be lower than the ordinary income tax rate.

That being said, it's critical that you estimate how much tax rates have to rise to make it profitable to give up the tax-deferred advantages that come with investments in a qualified retirement plan. (In fact, you may want to ask your tax advisor to help with the calculation.)

Another move worthy of consideration is converting your traditional IRA or other qualified retirement plan to a Roth IRA. Doing so would allow you to pay taxes at today's lower rates. (In our January issue, Marc Courtenay discussed Roth IRA conversions.)

Taxable Investment Accounts

The best way to handle assets that have meaningful capital gains, already in a taxable account, depends on more than a change in tax rates.

One factor is your age. When the estate tax is restored, Congress will likely continue the rule that no one pays taxes on capital gains accrued during your lifetime when you still own the assets at your death.

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The person inheriting an asset increases its tax basis to the current market value. At that point, the assets could be sold immediately for no taxable capital gain.

If this rule stays intact, the older you are, the less profitable it may be to sell assets to avoid a future capital gains tax hike.

You could hold them, and you and your heirs would avoid any taxes on the gains. But you would want to consider only the sale of assets you're likely to sell in the next few years.

For those with a longer-term investment horizon (i.e. - younger), taking some gains when a higher capital gains rate seems inevitable may look tempting.

Say you're seriously considering selling an asset in the next year or two. At face value, there doesn't seem to be a lot to consider. I mean, accelerating the sale to 2011 saves money on a move you'd be making soon, anyway, right?

But let's take a deeper look.

When your money will earn the same rate of return after the sale, there isn't much of an issue. You're better off paying the taxes now at the lower rate and moving the after-tax proceeds to another investment.

However, the decision isn't as easy when the new investment stands to earn a lower rate of return. In such a case, it may actually make sense to pay taxes on the sale later at the higher capital gains rate.

How much more would the current asset have to appreciate to justify holding it and paying the higher taxes in a year or two?

Consider: A capital gains tax hike from 15% to 20% represents about a one-third increase. Given that, the current investment would need an annual return more than one-third higher than the new investment's return to justify holding it and paying higher tax rates later.

Two Final Considerations

Before you sell any assets, don't forget about tax-loss carry forwards - losses you might have incurred in previous years that you weren't able to fully deduct. (For individuals, the limit is your capital gains for the year plus $3,000 per year.)

Given the brutal market in 2008 and early 2009, you might be sitting on a sizable amount of these carry forwards. You can use them to shield gains realized in future years.

Also, remember that today's lower long-term capital gains rate applies only when an asset is held for more than one year. Sell even one day early and you pay the ordinary income tax rate. So please double (and triple) check your entry dates before you sell.

In the end, there's no denying that after-tax returns are an important consideration. Sir John Templeton believed the consideration was of utmost importance, saying for all long-term investors there's only one objective - "maximum total return after taxes."

The extreme importance doesn't mean we should let the fear of tax hikes dictate our sell decisions, though. Instead, we need to carefully weigh the costs of buying and selling today against the potential tax savings. And only act when it makes sound fiscal sense.

Bob Carlson

Investment U Research

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