2012-2013 Fiscal Cliff Tax Strategy

As I write this, there is still no agreement between the President and Congress over a budget deal for 2013.

Gee, now there’s a surprise! Who could’ve predicted this??

Okay, humor and politics aside, no matter what agreement they reach, there are steps you can and should be taking right now to prepare yourself for one key area of the budget where you still retain some control: Capital Gains Tax Rates.

The one thing we already know is that tax rates on capital gains and investment income are going up in 2013 by 3.8% due to a provision in the Patient Protection and Affordable Care Act (i.e. Obamacare). As of today, this will apply to joint filers above $250,000 and single filers of $200,000.

What we don’t know yet is whether capital gains tax rates will also go up from 15% to 20%, or even higher.

Given this, I don’t recommend buying or selling anything yet, but I do recommend preparing for the announcement by doing some homework.

Before I share my recommendation, let’s quickly review capital gains tax law for a moment so we can clarify where this opportunity lies for you.

Capital Gains Tax Law

As a refresher, for investments you currently own outside of IRAs (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $150,000, you would owe capital gains taxes on the growth, i.e. $50,000.

On the flip side, however, if you purchased a stock or stock mutual fund for $100,000 and later sold it for $80,000, you can declare a capital loss of $20,000.

That $20,000 capital loss, while painful to realize, has significant value if handled properly. For example:

  1. You may use it to offset $20,000 of capital gains you realized in the same year, thus eliminating taxes on $20,000 of capital gains. This saves the average taxpayer a minimum of $3,000 in federal taxes in 2012, not to mention state taxes here in Massachusetts. (And, as you’ll discover shortly, possibly more in 2013 and beyond).
  2. If you don’t have $20,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year. That would save the average taxpayer approximately $750.
  3. You can then carry the unused portion ($17,000) over to next year and continue the same strategy. If you have a $17,000 gain next year, you can offset the entire tax due. If not, you can offset another $3,000 of ordinary income tax and carry the remaining $14,000 over to the following year.

An Opportunity From the ‘Dog Days’ of 2008-2009

Had you sold any investments during the downturn in 2008/2009, thus locking in and ‘realizing’ a capital loss, you now have the opportunity to recover some of your losses.

Or, if you have any investments held outside of IRAs that are currently in the red since you purchased them, you have an opportunity to lock in a capital loss right now and use it against your realized gains this or next year.

** The key point to grasp is that, if capital gains tax rates go up next year, any losses you had in the past that you’re carrying forward will be worth MORE to you next year.

So, if rates are definitely going to go up, carry your previously realized capital losses forward to use in 2013.

Here’s why: if you have $20,000 of capital losses that you’ve carried forward from prior years and you use them to offset $20,000 of capital gains in 2012, you save $3,000 in capital gains taxes.

However, if capital gains tax rates go up next year to 20%, and you’re also subject to the medicare surtax I mentioned above, thus increasing your capital gains tax rate to 23.8%, that same $20,000 capital loss will save you $4,760 instead of only $3,000!

Fiscal Cliff Capital Gains Tax Strategy

So you can be ready, my recommendation for you is three-fold:

  1. Pull out your 2011 federal income tax return. Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into 2012. And, if so, how much?
  2. Take a look at your realized and unrealized gain/loss positions in your non-IRA account statements.
    1. Have you already realized some gains in 2012?
    2. Do you have sizable unrealized gains that you may want to lock in right now in 2012 to avoid paying a higher capital gains tax rate in the future?
    3. Do you have any unrealized losses?
    4. Do you have any stocks or stock mutual funds that you’ve thought about selling, but haven’t pulled the trigger yet for one reason or another?
  3. If you own stock mutual funds, go to your fund company(s) website and you will typically find year-end “internal” capital gains distribution estimates. Do your best to determine what your short and long term gains will look like.

Once you’re armed with this information, now you’re ready to ACT when the President and Congress reach an agreement.

Remember that it’s your “net” investment returns (after taxes) that you get to spend! Paying more than you’re legally obligated to pay is not an act of patriotism. It’s laziness!

Take control in places where you still can!