Capital Gains Taxes May Rise: Should You Act Now?

It looks like Congress won't reach any resolution on the capital gains tax debate before November, so there's a reasonable chance that capital gains taxes may go up in 2011. Should you act now to beat the possibility of higher rates?

Well, that all depends on your specific tax status and your long-term objectives. One thing to remember about tax rates is we have a history of fluctuating rates. Low rates are generally followed by higher rates, and higher rates are generally followed by lower rates. Rates essentially shift as political power in Washington shifts, which means it's fair to assume that fluctuating tax rates will be a part of our future.

• If rates rise over the next few years, there's a reasonable chance that as political power shifts rates will come down at some point in the future.

Capital gains rates are now at 15% for most taxpayers, and look like they may go to 20% next year. If you own capital assets, should you sell now to lock-in the 15% rate?

If you're holding long-term capital assets, like stocks or real estate, and you have no compelling investment or business reason for selling them right now, it may not be a great idea to sell today. Yes, you may save 5% in taxes, but you could easily miss out on that amount of gain in the price of the asset if you sell it earlier than you otherwise intended, or you sell in a less than favorable market.

• Just look at how quickly the stock market moved up over the last three weeks. Prices on capital assets can change quickly, and any tax benefit you thought you got may be more than offset by a missed opportunity for price appreciation later.
• It's generally prudent to decide to sell based on your investment strategy, and then attempt to minimize the taxes associated with the sale. Sales that are driven primarily for tax reasons may actually cost you more in the long term.

Then consider it's possible rates could come back down in five or ten years. If you intended to hold the asset for the long-term, but sold today because of a fear of higher rates, you may have hurt yourself if you could have gotten that same rate several years down the line in a different political environment.

Now, if you have a long-term asset that you intend to sell sometime within the next year, then it might be worthwhile to consider selling it this year at what may be a lower capital gains tax rate. Because one year is such a short period of time when it comes to predicting whether asset prices will be up or down, and an increase in capital gains rates looks fairly likely, it may be a good decision to sell today and possibly pay less in taxes.

• If you've got some stocks you really aren't comfortable with, then the prospect of higher rates may be a good reason to sell today, assuming you have gains in those holdings. Or, if you have a concentrated position in one stock (employer stock or maybe an inheritance), and you know you need to diversify, the possibility of rising rates may be a good catalyst to make some changes this year.

Also, you have to consider that some of your investments won't be impacted by capital gains rates. Most people have the bulk of their investment wealth in their retirement plans, whether it be a 401(k), IRA or pension plan. Retirement plans are not subject to capital gains taxes. Your earnings in the plan are tax deferred and only distributions from plans are taxed. Moreover, the distributions are taxed as ordinary income, which has a completely different tax rate than the schedule for capital gains.

Finally, be sure that you fall into the category of people who might owe higher capital gains rates. At this time, the proposal from the Obama Administration is to raise capital gains rates for individuals earning more than $200,000 a year and families earning more than $250,000. If your income isn't above those levels, then you may still get the lower rate of 15%. Now, it's hard to tell whether the Obama Administration's position will be what we eventually get, but the point is not to overreact to the potential for higher rates if your income is below these levels.

• If you think you fall into a category of investor who may benefit from selling some assets today at the 15% rate, the next step is to check with your tax advisor. Tax rates are highly technical, and before you act, you should be sure that you'll get the intended benefit or are subject to the rates you think you're subject to.

Bottom line. Tax rates are driven by political power, and because power shifts can be surprising, so can the future of tax rates. If you want to act today, you should have an investment reason for making the change and then be pretty sure that you're in a category of investors who may be subject to higher future rates.

Above material does not constitute tax or investment advice. Consult your tax or investment advisor prior to making any decisions.
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