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This is the season many investors review their year-to-date gains and losses and scan their portfolios for any other year-end tax maneuvers. Historically, investors have sought to offset gains with losses—at least to the extent that such transactions make sense within the broader context of their investment strategy.
The general rule of thumb is to defer income and gains into the next tax year. In other words, why sell an asset for a taxable gain in December and pay the tax four months later when you could sell it in January and wait 15 months before paying the tax?
This year, however, the process takes a different twist. With the relative certainty that taxes are going to increase in some shape or form, many advisers are suggesting investors consider opportunities to accelerate income or realize gains in 2012.
Still, no one knows what the final tax rates are going to be or which tax deductions might be reduced or eliminated.
If the Bush tax cuts are allowed to expire, the highest marginal tax rate will increase from 35 percent to 39.5 percent; the maximum capital-gains rate increases from 15 percent to 20 percent. Dividend income will lose its current tax-favored “qualified rate” of 15 percent maximum and revert to being treated as ordinary income taxed at the investor’s marginal rate.
For investors who really get worked up about paying taxes on their investments, there are a couple of things worth remembering. First, taxes on investment gains are not the end of the world (after all, it means you’re making money). And frankly, investment decisions based solely on tax consequences usually are unwise.
In addition, one of the best tax shelters is available to any investor with discipline and the right mind-set: Buy and hold shares of good businesses for the long term. With no sale, the investor’s funds are allowed to grow and compound with the business, postponing the tax man.
In effect, a long-term investor can view the unrealized gain on his or her securities as a deferred tax liability analogous to an interest-free loan from the U.S. Treasury. The investor receives dividends and capital appreciation on the full amount of the investment, including the imbedded taxable gain.
The powerful effect of this internal compounding should not be discounted. When you pick up the paper and read about a large charitable gift made by a middle-class donor, it often is someone who held stock in a great business for a long time.
For a description of the power of compounding and deferring taxes, read the “taxes” section of Warren Buffett’s 1993 letter to Berkshire Hathaway shareholders (find it online at www.berkshirehathaway.com). In the letter, Buffett recalls a tale from the comic strip “Lil Abner” to demonstrate this point.
This strategy is in sharp contrast to tactics of the quick-buck crowd, who claim buy-and-hold is dead and believe they can dance in and out of investments and make a lot of money. If they manage to be successful—and that is a big if—they also are the ones paying taxes at the highest rates.•
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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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