Last-minute portfolio management in 2012

One cardinal rule in portfolio management is to seek tax efficiency when possible. Reducing the tax drag increases portfolio growth, spendable income, or both.

Another cardinal rule is, don’t let the tax tail wag the dog. A bad investment choice does not become a good choice because of its tax consequences.

Satisfying both rules is tricky when the tax consequences can’t be predicted with confidence. That’s the situation in which investors find themselves in December 2012, with the prospect of “taxamageddon” on January 1. The factors to consider:

• A new 3.8% tax on the long-term capital gains of higher-income taxpayers, created by the Affordable Care Act, definitely will go into effect.

• The President has called for increasing the nominal top tax rate on long-term gains from 15% to 20%, also for the higher-income taxpayers, the “top 2%.”

• In the event of a stalemate, top taxes on long-term gains will go up for everyone.

• No one expects taxes to go down in the near or medium term.

The prospect of higher taxes will create a bias toward selling before the end of the year, as investors lock in their gains at lower rates. For anyone planning to diversify out of a concentrated holding, an acceleration of that decision before the close of the tax year may save many tax dollars.

For those with longer time horizons, a 2012 sale may be less compelling. The problem with locking in lower tax rates is that the taxes still have to be paid. The portfolio will shrink, so future accumulations start with a smaller base. The financial benefit of tax deferral, even if rates are higher in the future, may be larger than the short-term tax savings. Much will depend upon how much an asset has appreciated, which governs the tax liability.

Example. Zeke, a top-bracket taxpayer, has an asset worth $200,000 that he bought for $20,000. That $180,000 gain will trigger a $27,000 tax if he sells it this year. If Zeke waits until next year, the tax zooms to $42,840! If he were considering a sale anyway, moving it to this year makes sense.

However, let’s say that Zeke reinvests his net proceeds, and for the sake of comparison we’ll assume his next investment performs just as his existing one does, appreciating 8% per year. In five years it will be worth $254,193. On the other hand, if Zeke skips the sale and the 2012 taxes his holding will grow to $293,866. True, he’ll have a lower tax basis, and a larger exposure to capital gains taxes. But who knows what the tax rates will be in five years, or whether Zeke can control his exposure by selling only part of his position?

In this challenging year, consult your tax advisors before taking any action.

(December 2012)