2010 Capital Gains Tax Planning

Posted on October 7, 2010 by David Laidlaw 

The Bush Tax cuts that were enacted in 2001 and 2003 are expiring at the end of this year bringing tax rates back to 2000 levels. The most important provisions from an investment perspective are the change in capital gains rate and level at which stock dividends are taxed.  Federal long-term capital gains tax rates are slated to increase from 15% to 20%.  Also, stock dividends will be taxed at current income tax rates and no longer receive a preferred rate.  

The healthcare legislation passed earlier this year also calls for an additional 3.8% Medicare tax to be applied to all “unearned income” for individual filers reporting more than $200,000 in total income and couples reporting more than $250,000.  Unearned income is tax-speak for capital gains, dividend and interest income.  These increases are slated to begin in 2013.  

Therefore, absent any additional tax legislation, capital gains tax rates are scheduled to increase to 20% next year and as high as 23.8% in three years.  Dividends may also be taxed at a Federal rate as high as 39.6% next year and 42.4% by 2013.  

Even given the challenging equity markets over the past few years, we manage many taxable individual accounts and trusts with large unrealized capital gains.  The likely tax increases raise the issue of whether or not it makes sense to realize tax gains this year to take advantage of lower rates.

Typically tax planning calls for delaying tax liabilities as long as possible since in inflationary environments a dollar today is worth more than that same dollar in the future. Therefore, the idea is to postpone any potential capital gains liabilities into the future as long as practical.  However, capital gains tax rates are slated to increase 33% next year and 56% by 2013 compared to current levels.  

There is a chance that this Congress or the next one that appears after November’s election will change these laws.  However, it is also possible that nothing happens and the rates rise dramatically as scheduled.  Any debates regarding tax policies are politically charged which often leads to paralysis as occurred with the estate tax, which Congress permitted to sunset this year.    Future Congresses could also change the tax structure to one that is more consumption-based or with lower capital gains rates.  Regardless, the Treasury is incredibly indebted and capital gains taxes have been a reliable revenue source for the government.

Our basic recommendation is that it probably makes sense to realize more gains this year than during a normal year due to the anticipation of higher rates.  However, each account must address this question based on its unique underlying circumstances.  

We look forward to having this conversation over the next couple of months.