Stock advice reversed to lock in tax at year end
High-income investors who plan to sell their winning stocks, funds or other investments in the next few years should consider doing so by Dec. 31 to lock in today’s tax rates. The same goes for employees who are planning to exercise stock options within a few years.
Normally at year end, advisers recommend selling losing investments to harvest tax losses that can be used to offset capital gains and — if losses exceed gains — up to $3,000 a year in ordinary income. But they generally tell clients to postpone selling their winners — and triggering capital gains tax — as long as it makes investment sense.
“We have all grown up with the idea you harvest losses and defer gains. It’s almost a tattoo we
have,” says Erik Davidson, deputy chief investment officer with Wells Fargo Private Bank. But in the next six weeks, high-income investors might want to “harvest gains, which is almost difficult to say, and defer losses.”
Tax-gain selling has probably contributed to the stock market’s 5 percent decline since the Nov. 6 election.
With Democrats maintaining control of the White House and Senate, tax increases that were approved as part of the Affordable Care Act are certain to take effect next year. Under this act, singles who have more than $200,000 in earned income (from a job or selfemployment) and joint filers with more than $250,000 will pay an extra 0.9 percent on earned income that exceeds those limits.
In addition, singles with more than $200,000 and joint filers with more than $250,000 in adjusted gross income will pay a 3.8 percent Medicare tax on their investment income, but only up to the difference between their AGI and those income limits. This is the first time Medicare tax has been levied on investment income.
There is a strong possibility that rates on ordinary income, capital gains and dividends will also go up for the wealthy next year.
Today, the top rate on dividends and long-term capital gains is 15 percent. If the Bush-era tax cuts expire at year end as scheduled, the top rate on capital gains will rise to 20 percent and dividends will be taxed as ordinary income, at rates up to 39.6 percent. President Obama has proposed letting those rates go into effect for singles with more than $200,000 and couples with more than $250,000 in adjusted gross income.
When to sell early
Selling an investment just to save taxes is rarely a good idea; you could give up more than you save if you bail on something and it then shoots up.
If you sell at a loss, you cannot purchase the same investment within 30 days before or after the sale or you will trigger the wash sale rule and lose your tax loss. However, this rule does not apply to stocks sold at a profit.
You can sell a winning investment and immediately repurchase it without affecting your tax situation. But you will still have to come up with the cash to pay your tax bill, leaving you less to reinvest.
If you are a wealthy investor and planning to unload a position anyway within four years — to diversify a concentrated investment or rebalance a portfolio — it’s a good idea to sell now to lock in today’s lower rates, says Patrick Geddes, chief investment officer of Aperio Group.
But it’s generally a bad idea if you plan to hold the investment long term because you will lose whatever return the money you pay in taxes could have earned.
It’s especially bad if you plan to hold the position for a lifetime. Under current law, your heirs will pay no tax on the difference between what you paid for the investment and its value at your death (although estate laws are subject to change).
Rebalancing
Kurt Brouwer, chairman of investment firm Brouwer & Janachowski, says he has been more willing to realize gains in investor portfolios this year “because we belive capital gains taxes are going higher next year.” He had a meeting with about 50 to 60 clients last week, and they all agreed.
Dan Rauchle, chief investment officer of Ascent Private Capital Management, says he wouldn’t want clients to “remodel their long-term portfolio” based on speculation about tax rates. But “if there is an intent to rebalance portfolios within the next six to 12 months, accelerating that now is probably a prudent thing to do.”
For example, U.S. stocks are up about 10 percent this year compared with 4 percent for stocks in foreign developed markets and 1.5 percent in emerging markets. If investors want to maintain a specific percentage of their portfolio in each of those three areas, they would sell some U.S. stocks and buy more foreign stocks.
Stock options
Employees with nonqualified stock options should also think about exercising them before year end in certain situations.
Options give the employee the right to purchase stock at a specific price, known as the exercise price, within a certain time, usually 10 years from the grant date.
When the market price rises above the exercise price, the option is said to be in the money and the employee can purchase the stock at the exercise price, assuming the option has vested. This is called exercising an option. The difference between the market price and the exercise price is the so-called spread or profit.
With a nonqualified option (the most common type), this profit is taxed as ordinary income, regardless of whether the employee holds or sells the stock he has just purchased.
If an employee is earning more than $200,000/ single or $250,000/married — or if the option exercise pushes him above this limit — any amount over the limit will also be subject to the extra 0.9 percent Medicare tax on earned income next year. He could also pay higher ordinary income tax if marginal rates go up.
If the option is exercised this year, the employee will avoid the extra Medicare tax, as well as a possible increase in marginal rates on ordinary income.
Another concern: If the employee waits until next year to exercise the option and the additional income pushes him over $200,000/$250,000 limit, some or all of his investment income (from capital gains, interest or dividends) could become subject to the new 3.8 percent Medicare surcharge, says Bruce Brumberg, editor in chief of myStockOptions.com.
Of course, once the option is exercised, it no longer has value (although the employee can continue to hold on to the stock).
In general, the closer the option is to expiring and the deeper it is in the money (the bigger the difference between the market price and strike price), the more sense it makes to exercise this year to avoid a potential tax increase, Brumberg says.
High-income workers should also consider exercising in-the-money options this year if they plan to change jobs soon because companies typically require vested options to be exercised within a certain period after departure, typically 90 days.
Employees have less control with restricted stock. The day it vests, the market value of the stock will be added to your ordinary income for the year. After that, it will be treated like any other stock investment.
For more on stock compensation, see tinyurl.com/chz7m2v.