Executive Summary
With the looming specter of not only the fiscal cliff with rising capital gains tax rates, but also the onset of the new 3.8% Medicare tax on net investment income in 2013, many investors have been looking to harvest capital gains before the end of the year.
The strategy is somewhat controversial, inasmuch as most taxpayers (and their accountants) have long since trained themselves to avoid ever paying taxes sooner than they absolutely have to, maximizing the value of tax deferral according to the basic principles of the time value of money. Nonetheless, the math of the situation with rising tax rates is quite straightforward, and in such environments it can require significant appreciation in a short period of time to make deferral worthwhile.
Harvesting Gains In Rising Rate Environments
Heading into 2013, there are two prospective tax increases looming on capital gains – the potential rise in the capital gains rate itself from 15% to 20% (and from 0% to 10% for those in the bottom two tax brackets), and the new 3.8% Medicare surtax on capital gains (and other investment income) for those with high income.
As a result, someone who has an investment with a $100,000 capital gain will owe $15,000 of taxes on it this year, but as much as $23,800 of taxes next year. Which means for tax deferral to be a good deal, the investor must grow the $15,000 of taxes that stay invested up to $23,800, just to break even, which is no small task, as it would require a whopping 59% appreciation rate. Certainly, an investment that may be held for a decade or two can generate such a return (growing 5%/year compounded for a decade for be more than enough), but for anything that may have been sold in the next few years anyway… it’s a very high hurdle rate.
Of course, the caveat is that if the $15,000 of not-yet-paid taxes remained invested, that growth too would generate additional capital gains, which means in reality the required appreciation rate is nearly 77% (growing $15,000 to almost $26,550 such that after a 23.8% tax rate next year, it would net out to $23,800).
The chart below shows the required appreciation necessary to recover from higher tax rates in 2013, depending on whether the increase is only the inclusion of the Medicare tax, only a lapse of current capital gains tax rates, or both. If the appreciation rate can’t be achieved before the investment is ultimately going to be sold anyway, the solution is simple: harvest the capital gain before the end of the year.
| Scenario |
Required Appreciation |
Required Appreciation w/ Taxes |
| 3.8% Medicare tax | 25.3% | 31.2% |
| 20% capital gains tax | 33.3% | 41.7% |
| Both of the above | 58.7% | 77.0% |
Some caveats do apply – most notably, that if the investment was going to be held until death (and receive a step-up in basis), it should continue to be held. In addition, state income taxes are a factor as well; although they’re generally stable, if the client was going to relocate to a state with a lower tax rate, that decrease in tax rates (from changing states) would reduce (or entirely eliminate) the required breakeven appreciation.
Nonetheless, the fundamental point remains – if the investment was going to be sold in the next few years anyway, these are potentially very significant appreciation rate hurdles to exceed to make deferral worthwhile, especially if there is any ongoing portfolio turnover (whether from an active advisor, ongoing risk management decisions, or an actively managed mutual fund).
And of course, for clients eligible for the 0% capital gains tax rate, there is no breakeven – the client can never recover for having forfeited the use of a “free” step-up in basis if the capital gains tax rate does in fact rise to 10% for those in the bottom two tax brackets!
The Value Of Tax Deferral
Notwithstanding the clear math of how much appreciation has to occur for tax deferral to be worthwhile (i.e., for capital gains harvesting to not work), many clients (and their accountants) have been resistant to harvesting capital gains, due to a general desire to avoid paying the looming tax liability.
Yet to a large extent, this demonstrates a fundamental confusion about what is, and is not, the value of tax deferral. Ultimately, a capital gains tax liability will be paid (at least, unless the investment is held until death for a step-up in basis), so trying to avoid capital gains to avoid ever paying the taxes due is an exercise in futility. Literally, if the client ever wants to use the money during his/her lifetime, the tax bill will have to be paid!
For instance, imagine the aforementioned investment that had a $100,000 gain was actually a $300,000 purchase that had appreciated to $400,000, representing a healthy (and probably multi-year) gain of 33% on the original investment. The reality is that the tax liability on $100,000 of capital gains will have to be paid someday (unless the money is lost, which clearly isn’t an improvement!); the value opportunity is to keep the current tax liability of $15,000 invested on the client’s behalf. At a moderate 8%/year growth rate, this means keeping the last $15,000 of future-tax-dollars invested allows for an additional return of $15,000 x 8% = $1,200/year. That’s the true economic value of tax deferral: an extra $1,200 of growth that could be earned and put in the client’s pocket, on the $15,000 of tax dollars available to keep invested before they’re turned over to Uncle Sam.
The problem, however, is that $1,200/year of economic value isn’t a great deal when higher tax rates could cost the client $3,800, $5,000, $8,800 (depending on whether the 15% capital gains tax rate rises to 18.8%, 20%, or 23.8%, respectively) in additional taxes (in reality, this is just another way to determine the breakeven rates calculated earlier).
Don't Let The Tax Deferral Tail Wag The Dog
In other words, the problem is not just that trying to maintain the value of tax deferral in the face of a potential 77% relative increase in tax rates may be an exercise in futility. It’s that trying to maintain the value of tax deferral may rarely ever be worthwhile, relative to even a small amount of market volatility! Or stated more simply: it’s virtually never worthwhile to let the tax tail wag the investment dog when it comes to deferring long-term capital gains, as even the tiniest of proactive investment decisions that preserve mere basis points of economic value can trump the benefit of tax deferral!
Of course, the reality of the math is that the larger the gain, the more economic value there is to maintaining tax deferral. Accordingly, the chart below shows the relative economic value of tax deferral at a 15% tax rate (and a 23.8% tax rate) depending on how large the underlying capital gain is.
| Appreciation | 15% tax rate | 23.8% tax rate |
| 10% | 0.109% | 0.173% |
| 20% | 0.200% | 0.317% |
| 30% | 0.277% | 0.439% |
| 40% | 0.343% | 0.544% |
| 50% | 0.400% | 0.635% |
| 60% | 0.450% | 0.714% |
| 70% | 0.494% | 0.784% |
| 80% | 0.533% | 0.846% |
| 90% | 0.568% | 0.902% |
| 100% | 0.600% | 0.952% |
Not surprisingly, the larger the gain (and the higher the tax rate), the more value there is to tax deferral. However, even for a scenario with 100% appreciation (which, notably, means the client may have already enjoyed years or a decade of tax deferral), the further benefit of deferring capital gains is still remarkably limited, especially relative to the volatility of asset classes like equities. And of course, most investors are holding investments with more “modest” appreciation, such as “only” 10%-30% growth, where the benefits of tax deferral are even more muted (not to mention that good asset location decisions should put higher turnover/higher return assets inside of tax-deferred retirement accounts, anyway!).
The bottom line? Simply put, be cautious about how much clients allow the tax tail to wag the investment dog. Not only is the value of capital gains tax deferral rather limited compared to the rather sizable looming tax rate increases, but the reality is that in most situations the benefit of tax deferral is so modest it really shouldn’t be viewed as a stumbling block to investment decisions, either.
(This article was featured as an Editor's Pick in the Carnival of Personal Finance "Happy New Year's Edition" on Good Financial Cents, the Carnival of Financial Planning on Savvy Scot, the Carnival of Money Pros - Snowman Edition on See Debt Run, the Carnival of Retirement 52nd Edition on Master the Art of Saving, and also the Carnival of Passive Investing #25 "Gingerbread House Edition" on Marotta on Money.)
Fully understanding and being able to explain to others the deferral “benefit” is on my bucket list. This article should help a lot with that, although I’ll have to read it a few more times.
I have always been troubled why a tax deferred IRA isn’t more advantageous than a ROTH, because with the deferred you get to hold onto the “government’s money”. But the ROTH and deferred IRA get the same results if tax rates hold steady, so there must be no advantage to holding onto the “government’s money”. Still seems to me there should be. It’s money in the IRA account earning a return that otherwise would not be there.
Harry,
There is still value to holding onto the government’s money in the case of a deferred IRA. It’s just that mathematically, it happens to be the same (present value) as the government giving you tax-free growth ON your money; that’s why traditional vs Roth IRAs come out “even” when tax rates hold steady.
A traditional IRA and its tax deferral still has value over holding money in a taxable account, though; that’s also why Roth conversions work better when the taxes are paid with outside taxable-account dollars (because you effectively reduce the amount in taxable accounts and increase the amount in tax-preferenced Roth accounts).
In the case of capital gains, though, the benefits are often FAR more modest. In part, that’s because we’re only talking about deferring taxes on the gains, and not the entire principal (as is the case with an IRA contribution). It’s also because portfolios tend to have some turnover every couple years (if not more rapidly), which makes the time horizon for capital gains tax deferral far less than the multi-decade time horizon for retirement accounts.
I’ll probably be doing another article on “the value of tax deferral” more broadly in the coming months, as it’s been increasingly popular as a point of discussion lately!
– Michael
Great post! Deferring a withdrawal is definitely common wisdom that is rarely challenged. It’s good to put things in perspective.
Unfortunately, my ESPP doesn’t exercise until February. I would have loved to have avoided the higher rates for one more year.
Can you please explain the assumptions behind the last matrix. (length of deferral, assumed return?) Thanks
Jason,
The chart is showing the annual benefit of tax deferred. The assumed growth rate is the same 8% as the example in the text from the prior section.
– Michael