Resetting Taxable Cost Basis Every Few Years

[eurowizard]

I'm curious if anyone resets the cost basis on their taxable equity positions every few years in anticipation of potential increased capital gain taxation?

The downside is paying the taxes every few years instead of at retirement. The upside is that you control how much taxes you are going to pay. Thus when you see $1M in your retirement account, you know that you actually have almost $1M rather than having $800k of stock appreciation that will be taxed.

Of course in recent years, just about everyone's equity positions have been tax-loss harvested. I am considering this moving forward.

Perhaps doing so in such a way that you just avoid AMT.

[Wagnerjb]

I wouldn't consider such a move. First of all, you are paying taxes early. Second, you are paying taxes you might be able to avoid (through donations, revaluation on death). Third, you are diluting the value of any tax losses you might be able to use against ordinary income.

Best wishes.

[livesoft]

I haven't had to because the stock market has done that for me. I do tax-loss harvesting whenever possible.

If you are only "considering this", you missed a fantastic opportunity in 2009. Why bother with thinking about resetting cost basis when you haven't done the TLH which has a clear benefit?

[Doc]

I'm curious if anyone resets the cost basis on their taxable equity positions every few years in anticipation of potential increased capital gain taxation?

Absolutely. At least up to the top of the 15% tax bracket, Andy's caveats aside. If you are in a higher bracket the decision is a little harder. The length of time of the investment comes into play and you have to weigh the tax deferment against the increased tax rate.

[sscritic]

Tax-loss harvesting resets the basis in a way which reduces current taxes and increases potential future taxes. Tax-gain harvesting resets the basis in a way which increases current taxes and reduces potential future taxes.

One strategy is to do both: takes loses in one fund and offsetting gains in another. Be prepared eventually to donate the fund that has the large built in gain and sell the fund with the gains already realized to support yourself.

In the end, the question comes back to whether there are circumstances in which paying taxes now is advantageous. Is anyone doing a Roth conversion this year?

[livesoft]

I would like to put in a case where tax-loss harvesting reduces future taxes as well. That's the beauty of it. Save money now and save money later.

My carryover losses will insure that I pay no capital gains taxes in the future even if the cap gains tax rate increases. Even though some of the carryover losses will be used against gains that would not have been there, I have shifted that extra income from my high tax years to my low tax years in the future when retired. I think it's win-win.

In contrast tax-gain harvesting appears to give me more income in my high-tax years and less in my low-tax years.

[Wagnerjb]

I would like to put in a case where tax-loss harvesting reduces future taxes as well. That's the beauty of it. Save money now and save money later.

My carryover losses will insure that I pay no capital gains taxes in the future even if the cap gains tax rate increases. Even though some of the carryover losses will be used against gains that would not have been there, I have shifted that extra income from my high tax years to my low tax years in the future when retired. I think it's win-win.

In contrast tax-gain harvesting appears to give me more income in my high-tax years and less in my low-tax years.

Livesoft - you can think of carryover losses as "insurance" against capital gains tax rate increases. Even if the CG rate goes to 85% (just an exageration, remain calm...), the losses you generated at 15% will offset the gains on a before tax basis.

And when you use the Capital Losses against ordinary income, you are converting 15% (future) benefits into 30% benefits today. The arbitrage is nice if you are in higher tax brackets.

I can see Doc's point about realizing capital gains if you pay 0% tax on them. However, folks like me (and others) who have a built up Capital Loss Carryover cannot use this approach, lest we use up tax losses instead. (The fact that my tax rate is much higher than 15% makes the issue moot anyway...)

Best wishes.

[sscritic]

I would like to put in a case where tax-loss harvesting reduces future taxes as well. That's the beauty of it. Save money now and save money later.

My carryover losses will insure that I pay no capital gains taxes in the future even if the cap gains tax rate increases. Even though some of the carryover losses will be used against gains that would not have been there, I have shifted that extra income from my high tax years to my low tax years in the future when retired. I think it's win-win.

In contrast tax-gain harvesting appears to give me more income in my high-tax years and less in my low-tax years.

So you won't convert to a Roth, since your tax rate today is higher than your future tax rate. That is not true of everyone, or at least there are some people acting as if their future tax rate will be comparable or higher than their current tax rate.

[livesoft]

I agree that everyone has to look at their own personal situation. I agree that if Doc is getting taxed at 0% for realizing cap gains, then why shouldn't that happen?

I will do Roth conversions in the future when they won't cost me as much as they would now. Thank you.

[sscritic]

Livesoft - you can think of carryover losses as "insurance" against capital gains tax rate increases. Even if the CG rate goes to 85% (just an exageration, remain calm...), the losses you generated at 15% will offset the gains on a before tax basis.

Just an exaggeration, remain calm, but what if when they change the tax law to raise the capital gains rate to 85% they also change the law on tax-loss carryforward. Just like when a country revalues a currency, they could declare that old losses could only be used on a 5-1 basis against new gains ($5 of old losses offsets $1 of new gains). Just sayin'.

[livesoft]

If they did that -- to put it politely -- I would be screwed.

[eurowizard]

I wasn't quite clear enough in my original post. My idea is to reset the cost basis every few years, sometimes at a tax-gain, and sometimes at a tax-loss. I would not avoid TLH.

The exact amount of TLH or tax-payments would be based on the tax-bracket of that year and where I want to push myself to maximize other things that might have phaseouts.

For example, one year using capital losses of $3k to offset normal income, and in the next year, taking some gains at preferred long-term cap gain rate and avoiding any losses that would only offset the lower tax rate. Perhaps alternating years in which you take gains or losses, entirely dependant on your personal tax and overall market conditions.

[Wagnerjb]

So you won't convert to a Roth, since your tax rate today is higher than your future tax rate. That is not true of everyone, or at least there are some people acting as if their future tax rate will be comparable or higher than their current tax rate.

While these situation sound similar, they are very different.

The Roth vs. Traditional IRA decision is a wash when today's tax rate is identical to tomorrow's tax rate. Due to the tax-free nature of the Roth and the tax-deferred compounding of the TIRA, the "time value of money" isn't relevant to this decision. Just the rates.

The tax loss harvesting issue is NOT a wash when today's tax rate is identical to tomorrow's tax rate. Saving taxes today and paying them tomorrow (at identical rates) is a clear winner due to the time value of money.

(I have kept the issues simple to demonstrate the point. Some will be tempted to pollute the analysis by suggesting that the taxpayer may never pay the CG if he dies with appreciated assets.....or that the Roth may be taxed indirectly in the future. These are valid issues to debate, but in some other post )

Best wishes.

[Wagnerjb]

Livesoft - you can think of carryover losses as "insurance" against capital gains tax rate increases. Even if the CG rate goes to 85% (just an exageration, remain calm...), the losses you generated at 15% will offset the gains on a before tax basis.

Just an exaggeration, remain calm, but what if when they change the tax law to raise the capital gains rate to 85% they also change the law on tax-loss carryforward. Just like when a country revalues a currency, they could declare that old losses could only be used on a 5-1 basis against new gains ($5 of old losses offsets $1 of new gains). Just sayin'.

Fair enough. Then you would have a fair deal on the TLH carryforwards. But in the meantime, you "won" by using some of the 15% capital losses against ordinary income in the 30% bracket.

Even if they reset the ratio for capital loss carryovers, you still have benefits. First, you have the $3000 per year against ordinary income in the 30% bracket. Second, you have the time value of money because you have deferred paying capital gains tax.

Best wishes.

[Doc]

I wasn't quite clear enough in my original post. My idea is to reset the cost basis every few years, sometimes at a tax-gain, and sometimes at a tax-loss. I would not avoid TLH.

The exact amount of TLH or tax-payments would be based on the tax-bracket of that year and where I want to push myself to maximize other things that might have phaseouts.

For example, one year using capital losses of $3k to offset normal income, and in the next year, taking some gains at preferred long-term cap gain rate and avoiding any losses that would only offset the lower tax rate. Perhaps alternating years in which you take gains or losses, entirely dependant on your personal tax and overall market conditions.

In case I wasn't clear in my original response. Absolutely.

We are in the relatively unique position to be able to control the timing of our taxable income to a large degree. We therefore take CG gains or losses to minimize (future) CG taxes one year and take losses to avoid "phases outs" in another year. Picking up on Andy's point, maybe we can get congress to let us use our carry overs when we want to instead of when the IRS tells us to.

[bb]

A few of the papers I have read regarding asset location seem to indicate
that part of the rationale for locating stocks in taxable accounts is that
paying taxes on capital gains can be deferred. One of the the papers
pointed out the longer the holding period the lower the effective capital
gains tax would be.

Would that be a fairly strong argument against realizing gains?

[eurowizard]

A few of the papers I have read regarding asset location seem to indicate
that part of the rationale for locating stocks in taxable accounts is that
paying taxes on capital gains can be deferred. One of the the papers
pointed out the longer the holding period the lower the effective capital
gains tax would be.

Would that be a fairly strong argument against realizing gains?

Yes, that can be a strong argument against realizing gains, which is why it's the current standard logic.

Here are some issues to consider that may make resetting the cost-basis seem reasonable:

1) Imagine you are really young, in your 20s. You max out your 401k and IRA and still have some room left over. Because of the deductions, you are in the 15% bracket. You could reset the cost basis on your stocks every year for 15%, or you could sit on them, and hope that the tax wont go up over the next 40 years. Considering the history of long term capital gains over the last 40 years has been variable, there's a great chance that it will continue to change in the future. Thus paying the tax now every few years reduces risk of tax increases.

2) If you get divorced, the judge will split assets based on their current value. Guess who gets to pay the taxes on all the gains out of their "half" of the money? So you have $100k in appreciated stocks with a cost basis of $20k. The judge orders each get $50k. You are on the hook for $80k worth of taxes on your $50k "half," under SOME circumstances in SOME states.

3) If you get arrested, the judge will have a hearing to see if you qualify for a public defender. If you have $100k with a $20k cost basis, the judge assumes you have $100k to pay for a lawyer. He doesn't take into account that you owe taxes on $80k and selling it in one year will push you into AMT. If the long-term capital gains preference expires then this $100k may be $50k after additional AMT taxation on other earnings, and taxes on the stock earnings.

4) If you apply for FAFSA for you or your child they count the amount you have, not the after-tax amount you have.

5) You may need a large sum of money in an emergency, and selling all your stock at once will invoke AMT and a higher tax rate for your other income.

6) If you get sued, or if someone THINKS about sueing you, they check your assets. They dont check the cost basis of your assets. So you look like a huge target if you have appreciated stock that you have been deferring taxes. And if you lose the lawsuit, then the award will be based on what you have. The judge will disregard your tax-liability. Then you go to jail for tax-avasion because the creditor took all your money.

Many of you will read this issues and think they are silly and will never apply to you. Many of you will be right. Personally I think it's reasonable to reset the cost basis every few years, provided you can do so in a tax-efficient way.

[tetractys]

I'm curious if anyone resets the cost basis on their taxable equity positions every few years in anticipation of potential increased capital gain taxation?

I believe capital gain taxation moves around an equilibrium, where overly high or low capital gain taxes decreases revenues, and where taxing agencies know the sweet spot from experience. So trying to time cost basis resets would likely be fruitless or even detrimental.

Best regards, Tet

[billern]

I'm curious if anyone resets the cost basis on their taxable equity positions every few years in anticipation of potential increased capital gain taxation?

I believe capital gain taxation moves around an equilibrium, where overly high or low capital gain taxes decreases revenues, and where taxing agencies know the sweet spot from experience. So trying to time cost basis resets would likely be fruitless or even detrimental.

Best regards, Tet

I'm not sure that taxation (and related tax rates) are that efficient.

The other thing to factor into any discussion of tax planning is that no capital gains tax is paid at all on securities held until death. The cost basis is stepped up to the fair market value on date of death. If the funds may be held until death (for heirs or the spouse's benefit), it is counter-productive to pay capital gains on those securities every few years.

[jon-nyc]

Thinking the 15% CG rate wouldn't be with us forever, I did the math on 'tax gain harvesting' a while ago. My calculations showed it probably wouldn't make financial sense.

[neverknow]

..

[ddb]

The Roth vs. Traditional IRA decision is a wash when today's tax rate is identical to tomorrow's tax rate. Due to the tax-free nature of the Roth and the tax-deferred compounding of the TIRA, the "time value of money" isn't relevant to this decision. Just the rates.

So many people, including the dozens of journalists scrambling to write articles about the Roth conversion "hot topic of the day", fail to understand what you have put so simply.

- DDB

[droliver]

The Roth vs. Traditional IRA decision is a wash when today's tax rate is identical to tomorrow's tax rate. Due to the tax-free nature of the Roth and the tax-deferred compounding of the TIRA, the "time value of money" isn't relevant to this decision. Just the rates......
(I have kept the issues simple to demonstrate the point. Some will be tempted to pollute the analysis by suggesting that the taxpayer may never pay the CG if he dies with appreciated assets.....or that the Roth may be taxed indirectly in the future. These are valid issues to debate, but in some other post.

You're not getting off that easy!

It is utterly implausible that the ROTH account is not going to be targeted for some kind of taxation down the road that is going to have disruptive effects on the kinds of tax planning everyone is talking about with the Roth's right now. It will all start with the idea of having the rich "pay their share" from the democrats in congress. It's just too big a pot of gold for big government to ignore when it comes time to pay for the next entitlement or finance the US debt.

[chuck-lyn]

Although I like the "fair tax" concept of a revenue system based on a national sales tax, it would be a ROTH killer.

I don't think gov would ever be sane enough to scrap the income tax based system so I don't worry about it (much).

The reason I am pushing to convert my IRA to a ROTH is because of the potential tax bracket of my heirs. That and because I just want to leave them a tax free gift from Papa. If the gov does anything to screw that up I will haunt them!

Cheers,

charlie

[adam1712]

1) Imagine you are really young, in your 20s. You max out your 401k and IRA and still have some room left over. Because of the deductions, you are in the 15% bracket. You could reset the cost basis on your stocks every year for 15%, or you could sit on them, and hope that the tax wont go up over the next 40 years. Considering the history of long term capital gains over the last 40 years has been variable, there's a great chance that it will continue to change in the future. Thus paying the tax now every few years reduces risk of tax increases.

I think it is nearly impossible for taxes to increase enough for this to be the right move. As an example:

Let's say you have $1000 now worth $1500 so you have a $500 gain. If you realize the gain and pay 15% tax or $75.

Now, if the returns are 5% over the next 40 years, that $75 could become:

$75*1.05^40 = $528

So if you don't realize the gain you have an extra $528 but have $500 more in capital gains. The capital gains rate would have to be 105% (which is impossible) for this to be the right move.

[eurowizard]

I think it is nearly impossible for taxes to increase enough for this to be the right move. As an example:

Let's say you have $1000 now worth $1500 so you have a $500 gain. If you realize the gain and pay 15% tax or $75.

Now, if the returns are 5% over the next 40 years, that $75 could become:

$75*1.05^40 = $528

So if you don't realize the gain you have an extra $528 but have $500 more in capital gains. The capital gains rate would have to be 105% (which is impossible) for this to be the right move.

I just ran the numbers and got 85% tax rate, but your point is valid. I never ran the numbers before. I'll play with them some more and see what I come up with.

For math's sake, here is how I got 85% tax rate using your example:

If you do pay taxes now you have 1425*1.05^40 after 40 years

If you do not pay taxes now you have 1500*1.05^40 after 40 years but you must subtract the tax you didn't pay which is (500*1.05^40) * (1-tax rate)

Using algebra and solving for tax rate and I got 85% but it's late so someone please check my math.

[TheEternalVortex]

I think it is nearly impossible for taxes to increase enough for this to be the right move. As an example:

Let's say you have $1000 now worth $1500 so you have a $500 gain. If you realize the gain and pay 15% tax or $75.

Now, if the returns are 5% over the next 40 years, that $75 could become:

$75*1.05^40 = $528

So if you don't realize the gain you have an extra $528 but have $500 more in capital gains. The capital gains rate would have to be 105% (which is impossible) for this to be the right move.

I just ran the numbers and got 85% tax rate, but your point is valid. I never ran the numbers before. I'll play with them some more and see what I come up with.

For math's sake, here is how I got 85% tax rate using your example:

If you do pay taxes now you have 1425*1.05^40 after 40 years

If you do not pay taxes now you have 1500*1.05^40 after 40 years but you must subtract the tax you didn't pay which is (500*1.05^40) * (1-tax rate)

Using algebra and solving for tax rate and I got 85% but it's late so someone please check my math.

I get that they are equal at about a 55% tax rate. Still seems to suggest that doing this makes no sense.

[Jack]

It is utterly implausible that the ROTH account is not going to be targeted for some kind of taxation down the road ... It's just too big a pot of gold for big government to ignore ...

Actually you are wrong about the big pot. It's a pretty tiny pot, small enough to ignore. There are about 9000 billion dollars in retirement accounts in the U.S. Only 225 billion of that is in Roth IRAs, about 2.5%. So 97.5% of retirement accounts are already taxable and only 2.5% are non-taxable Roths. Why would they even bother going after the taxes on that tiny portion? At a 25% tax rate and over a period of years it would have almost no effect on the debt, just a few billion dollars. It's chump change not worth the political backlash.

[uncleJohn]

.....let's not forget that in 2010 there is no step in basis at death as part of the modified carryover basis rule. Whether this will continue as part of the potential changes in the estate tax legislation remains to be seen. If there are existing losses in a taxable estate it could very well make sense to realize gains to increase your basis.

[Still Learning]

The Roth vs. Traditional IRA decision is a wash when today's tax rate is identical to tomorrow's tax rate. Due to the tax-free nature of the Roth and the tax-deferred compounding of the TIRA, the "time value of money" isn't relevant to this decision. Just the rates.

So many people, including the dozens of journalists scrambling to write articles about the Roth conversion "hot topic of the day", fail to understand what you have put so simply.

- DDB

Not true in many situations.

The TIRA has required minimum distributions and the Roth does not.
Tax free compounding over the life of the owner and her beneficiaries adds significant value to the Roth.

S L

[Still Learning]

.....let's not forget that in 2010 there is no step in basis at death as part of the modified carryover basis rule. Whether this will continue as part of the potential changes in the estate tax legislation remains to be seen. If there are existing losses in a taxable estate it could very well make sense to realize gains to increase your basis.

This indicates that in 2010 an estate is granted additional (step-up) basis of $1.3 million plus an extra $3 million for spouses (total $4.3 m)

http://www.statefarm.com/insurance/life ... axgone.asp

For the year 2010, "step-up" will be replaced by "carry-over basis" rules. Carry-over basis generally means the basis of inherited property remains the same as it was for the deceased owner; which potentially increases the amount of gain (and tax) when the property is sold. When property is inherited, the heir can choose to take a "step-up" in basis for only $1.3 million of the property. For any amount inherited over $1.3 million, the heir's basis will be the smaller of the deceased owner's basis or the date-of-death-market value. The basis of property passing to a surviving spouse can be increased by an additional $3 million.

Remember, in 2011, step-up in basis generally resumes as it existed prior to this Act, because all provisions of this tax act expire after December 31, 2010.

So it looks like smaller estates are not affected and large estates still get partial step-up.

S L

[ddb]

The Roth vs. Traditional IRA decision is a wash when today's tax rate is identical to tomorrow's tax rate. Due to the tax-free nature of the Roth and the tax-deferred compounding of the TIRA, the "time value of money" isn't relevant to this decision. Just the rates.

So many people, including the dozens of journalists scrambling to write articles about the Roth conversion "hot topic of the day", fail to understand what you have put so simply.

Not true in many situations.

The TIRA has required minimum distributions and the Roth does not.
Tax free compounding over the life of the owner and her beneficiaries adds significant value to the Roth.

You are correct, but this does not reflect "many situations", but only those who would elect to not take at least their RMD if they weren't required to. Plus, doesn't matter for the beneficiaries, since beneficiaries have to take RMDs from any inherited IRA, Roth or not.

Plus, the lack-of-RMD issue on the Roth is a very difficult one to analyze, because you have to get into lots of other issues, including whether the investor takes funds from other places instead, and if so, is he missing out on some cost basis step-up opportunities at death, etc.

Here's an educated guess on my part: if a person converts today, even at a higher tax rate than the RMD and/or beneficiary withdrawals would be taxed at, they'd still be better off not converting if they didn't otherwise need to take RMDs. They could place the after-tax RMD in a side taxable account invested in a tax-efficient manner.

- DDB

[uncleJohn]

Still Learning:

That is correct....I should have used "there is no FULL step up in basis" to be accurate.

It still could make sense for estates to realize gains to the extent of prior-year losses.

[Still Learning]

Still Learning:

That is correct....I should have used "there is no FULL step up in basis" to be accurate.

It still could make sense for estates to realize gains to the extent of prior-year losses.

I read the 2010 rule as meaning there's a full step up in basis for the "smaller" estates.

Is that not correct?

S L

[Still Learning]

Hi ddb

Good discussion

RE: Plus, doesn't matter for the beneficiaries, since beneficiaries have to take RMDs from any inherited IRA, Roth or not.

Yes it does matter.
With the TIRA, after RMDs, there is a smaller balance to inherit than with the Roth and no RMDs. The inherited Roth benefits the beneficiary because of the larger balance that continues to compound tax free.

Re: missing out on some cost basis step-up opportunities at death

True this is a negative for paying the tax on Roth conversions when investments are in stocks or other investments where most of the return is due to price appreciation. But it's not much of a consideration for fixed income.

Re: if a person converts today, even at a higher tax rate than the RMD and/or beneficiary withdrawals would be taxed at, they'd still be better off not converting if they didn't otherwise need to take RMDs.

Of course, when the conversion tax rate is greater than the rate on RMD withdrawals, the Roth advantages are diminished.

Re: They could place the after-tax RMD in a side taxable account invested in a tax-efficient manner.

Folks pay a price in lower returns for "tax efficient" investing. For example munis return less than taxable bonds and tax efficient funds return less than equivalent taxable funds while still paying taxable dividends.

S L

[ddb]

Hi ddb

Good discussion

RE: Plus, doesn't matter for the beneficiaries, since beneficiaries have to take RMDs from any inherited IRA, Roth or not.

Yes it does matter.
With the TIRA, after RMDs, there is a smaller balance to inherit than with the Roth and no RMDs. The inherited Roth benefits the beneficiary because of the larger balance that continues to compound tax free.

That's why I mentioned placing non-needed RMDs in a side taxable account (which would also be passed along to beneficiaries, with a step-up in basis on appreciated assets).

Re: They could place the after-tax RMD in a side taxable account invested in a tax-efficient manner.

Folks pay a price in lower returns for "tax efficient" investing. For example munis return less than taxable bonds and tax efficient funds return less than equivalent taxable funds while still paying taxable dividends.

Major disagreement here. Use taxable account to buy equities only, increase bond holdings in tax-deferred accounts. No loss of expected return, extremely tax-efficient.

- DDB

[bluto]

If you qualify for the FEIE, you can tax-gain harvest a small amount every year to use up the standard deduction. It isn't huge, (5,700 - 11,400 this year) but side-stepping $11,400 makes a nice difference over time.

[Still Learning]

Hi again DDB

Re: That's why I mentioned placing non-needed RMDs in a side taxable account (which would also be passed along to beneficiaries, with a step-up in basis on appreciated assets).

But in your scenario the RMDs have moved from a tax deferred account to taxable. So at the owner's death the beneficiaries inherit the TIRA residual (smaller amount than would have been in the Roth) and pay taxes on each year's distribution. They also inherit the "side account" that throws off taxable income. Compared to a Roth the beneficiaries lose because the Roth provides tax free compounding. For young beneficiaries this loss is greater because the Roth benefit compounds over their longer life.

Re: Use taxable account to buy equities only, increase bond holdings in tax-deferred accounts. No loss of expected return, extremely tax-efficient.

Sounds good, but some additional things to consider-
The "side investments" pay dividends and realized gains to the owner that are taxable.
The residual of the side account that is inherited similarly pays taxable distributions to the beneficiaries.
For the Roth their is no tax on income.
Yes the step up in basis on death is important, but the full value is only realized if appreciated assets are held and never sold. This could be a very long time. This reduces the owner's options to change/rebalance her investments during her lifetime.
Folks may need some fixed income in taxable accounts and may not have room for added stock holdings.

There are pros and cons to each approach that affect people differently. Good to discuss these points

S L

[pshonore]

If you qualify for the FEIE, you can tax-gain harvest a small amount every year to use up the standard deduction. It isn't huge, (5,700 - 11,400 this year) but side-stepping $11,400 makes a nice difference over time.

Whats the FEIE ?

[bluto]

If you qualify for the FEIE, you can tax-gain harvest a small amount every year to use up the standard deduction. It isn't huge, (5,700 - 11,400 this year) but side-stepping $11,400 makes a nice difference over time.

Whats the FEIE ?

Foreign earned income exclusion. Sorry about that.