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Defer Taxable Income or Accelerate Gains?

As we approach the presidential election, investors are wondering whether it makes sense to take long-term gains early.

As we approach the presidential election, investors are wondering whether it makes sense to take long-term gains early.

Indeed, a consensus seems to be building that investors should rush out and take gains right now to take advantage of the current rate, just in case democratic presidential candidate Barack Obama gets into office and raises the rate.

But we at Twenty-First Securities believe investors should do nothing this year and only sell next year if they already had decided, independent of presidential politics, to sell sometime in the next few years.

How’s that? Well, let’s do the math.

Deferring into a higher tax rate only works when one expects double-digit returns or long time frames.

If tax rates were constant, the decision on using tax-deferred vehicles would be easy. You'd simply measure the annual costs of the deferring mechanism (the cost of a non-deductible individual retirement account or an annuity, for example) versus the appreciation that occurs when compounding takes place outside the taxman's reach.

Consider what happens to an investment in a 35 percent tax environment. If income generated by the investment is deferred, $100 of investment income will get reinvested instead of $65 (the $100 minus a 35 percent tax).

Profits from the deferral come exclusively from the earnings on the $35 spared from current taxes. If the cost of deferral is 1 percent, the investor need only earn a 3 percent return for the deferral to make sense at today's 35 percent tax rate.

The math would be easy if that was all there was to it. But, of course, there's more to consider.

Let History Be Your Guide

Most investors who analyze deferral mechanisms assume that the tax rates in effect when funds are withdrawn from deferred accounts will be the same as the rates when money is deposited. If history is any guide, that assumption should prove wrong. When I started in the brokerage business, investment income was taxed at 70 percent. That's right, 70 percent, right here in the United States.

When the 16th Amendment introduced the income tax in 1913, the top rate was only 7 percent. Within a decade, it rose to 77 percent. At the end of World War II, the top marginal rate was 94 percent. President John F. Kennedy lowered it to 70 percent, where the rate basically remained until 1981. Ronald Reagan sliced it to 28 percent. The rate that prevails in your retirement years may depend on who is president at the time.

Today's top rate of 35 percent doesn't look so bad when you look at it in the context of where we've been or where we might find ourselves as baby boomers age. Remember the line from The Beatles' song "Taxman"? It went: "There's one for you, 19 for me," reflecting the United Kingdom's 95 percent maximum tax rate.

No matter the rate, if money is deferred long enough and invested profitably enough, the wonders of compounding can overcome even very high tax rates.

Let's look at some examples:

Assume that investment income will be taxed at 50 percent when withdrawn in 10 years. At that tax rate, an investor has to earn 15 percent annually for the deferral to have made sense. The hurdle return needed drops to 7 percent annually assuming 20 years of deferral.

Alternatively, an investor can calculate the future tax rate that would turn her plans upside down if lots of income were deferred until the golden years. For example, someone cashing out 20 years from now in an environment with a 70 percent tax rate will have to earn more than 18.5 percent a year on her money over those two decades to overcome the effect of such a high rate.

Deferral mechanisms and the magic of pretax compounding can be tantalizing, but the decision to utilize these strategies should be tempered by analyzing the devastating effects of higher future tax rates. An interactive tool to make the calculations is available to the public at

No Matter Who Becomes President

Many expect capital gains tax rates to increase no matter which presidential candidate wins. Obama has declared that he wants the capital gains tax rate raised to 20 percent from its current level of 15 percent.

If the Republicans win it’s believed that they will not have enough votes in Congress to stop the automatic 2010 rollback of the Bush tax cuts. But there should be no rush to sell now, certainly not before the election results are in. Even after the election there should be no reason to rush to sell this year.

And what about next year?

Historically, anytime there has been a change in the capital gains tax rate, the date for the change has not been applied retrospectively. If this trend holds true, investors will have full warning when the change will take place. This advance warning also helps the government raise revenues because an impending increase in capital gains rates is usually accompanied by an out-sized amount of selling to take advantage of the lower rate still in effect (but about to be eliminated).

If the Republicans win the higher rate isn’t scheduled to return until Jan. 1, 2011, so any selling would begin in 2010. If the Democrats win, the inauguration does not take place until mid-January, and after that, Congress will need to debate the merits and pass a bill to institute higher rates.

I use the term “take advantage of lower tax rates” cautiously, because investors may not be better off using this strategy. Certainly, if the investor knows that he will be selling in the next few years, the strategy can make sense.

But to a long-term holder, the benefits are less certain. It is important to remember that individual investors in the United States are forgiven capital gains taxes at death through a step-up in basis. Even investors planning on holding investments nine years or more should consider that another administration will be in place by then, with its own ideas about tax rates (and the possibility that rates will come back down).

If a sale is to be made today, investors need to consider the “costs” as well. For example, is a 20 percent tax paid in 2013 actually worse than a 15 percent tax paid in 2008? Investors who sell today will deplete the amount of money available for investing. If they hold off paying the tax, those tax dollars could still be at work in the markets. What rate of return would make an investor indifferent to paying the capital gains tax at the current rates, versus the higher possible capital gains rates in the future?

Let’s look at the rate of return that needs to be earned when making the pay-now-or-later decision, assuming the current tax rate on capital gains is 15 percent for the federal government and 7 percent from the state:

Tax Rates

5 Years

10 Years

15 Years

20 Years

20% Federal + 7% State





28% Federal + 7% State





What we see is that an investor would need to earn only 2 percent annually over the next 10 years to make paying a 20 percent tax in 2018 preferable to paying a 15 percent tax in 2008.

Investors are right to be on the alert for higher capital gains taxes, but immediate action is imprudent. We advise waiting to see how the election goes before any action is taken.

If Democratic candidate Obama wins, we predict that a July 1, 2009, effective date is the earliest we would see a higher rate. If Republican candidate McCain wins, investors can wait even longer to see how this plays out.

For investors with long time horizons, it may be best to keep informed—but do nothing even if capital gains rates are scheduled to increase.

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