Should retirees sell now if taxes will be greater next year?
Henry K. Hebeler
6-13-08*
Do you expect tax rates to increase appreciably? What if I have most of my investments in deferred-tax accounts and the tax rate would go up next year? Would I be better off liquidating the account now when ordinary tax rates are low? Or suppose I have large amounts of unrealized gains (market price less cost basis) in taxable accounts? Should I take the tax hit now when capital gains rates are low?
The answers to these questions have a major effect on me personally because I am in a high tax bracket. I set up the following assumptions:
The following charts illustrate my conclusions. All of the charts have the same things in common. The initial investment amount was $100,000. They all assume that I will have constant inflation-adjusted retirement spending with an inflation rate of 4%. Spending is on an after-tax basis.
First let us look at deferred-tax accounts such as my 401(k) and IRAs. In my case, I use a 25 year life-expectancy. The results in Figure 1 depend on both returns on investments as well as the amount of after-tax deposits. After-tax deposits are shown as a percent of my current deferred-tax investments. The two choices are to continue to hold the investments in deferred-tax accounts or to liquidate the deferred-tax accounts when tax rates are low and reinvest the money in taxable accounts which still would likely have a lower dividend tax rate than ordinary income tax rates.
The conclusions I reached for my deferred-tax accounts are that I should continue to hold because almost all of my contributions were on a pre-tax basis so I had few after-tax deposits. Any benefit from selling now would be very small, even with such a large ordinary tax increase. A retiree who has significant after-tax deposits and expects a high return throughout retirement should definitely resist selling now.
What about my taxable accounts? I have large unrealized gains in most of these accounts because I have invested heavily in tax-managed funds years ago. They have had virtually no capital gains distributions over all of these years. It’s been just like having bought a stock years ago that has grown appreciably in value.
Figure 2 shows that I would be able to spend less in my retirement if I liquidated my taxable accounts now. I concluded that I should just hold all of my taxable investments.
In my particular case, I expect that there is a reasonable chance that I will be able to leave an inheritance for my children. In that case, there is an overpowering reason that would encourage me to hold my taxable investments with large capital gains. That’s because under current law, on my death the capital gains will go untaxed since the funds will get a new cost basis based on the market at my death.
I also looked at what would happen if tax rates stayed the same, but I had decided to reinvest now anyway. I found that the penalty would be very great for the deferred-tax accounts and also for the taxable accounts, although the penalty for liquidating the taxable accounts now would be much smaller.
How about some of my older retiree friends using life expectancies of 10 years?
In the case when retirees are in the eighties or nineties, they might choose to use considerably less than 25 years for life expectancies. So I looked at a case for 10 year life expectancies when the results start to get a little fuzzier.
Figure 3 shows the effects of different alternatives for deferred-tax accounts. If you had made mostly pre-tax deposits as have most people, there would be a benefit to selling now and reinvesting in a taxable account, but not if you still had an appreciable fraction of your investments represented by after-tax deposits. Most retirees with short life expectancies should consider selling deferred-tax accounts but only if they are really confident that ordinary income tax rates will increase significantly—and then only after doing an analysis for their own particular case by using a computer program such as the Pre and Post Retirement Planner on www.analyzenow.com.
What about taxable accounts when you might only need the money for 10 years? Figure 4 illustrates the results from that situation.
Retirees with a short life-expectancy who had held a tax managed fund or a particular stock for a long time and therefore had large unrealized gains might do well to sell now if they are confident that dividend and capital gains rates will increase shortly. Obviously the day trader or someone with a fund with high turnover would have little unrealized gains, so it wouldn’t make any difference which whether he/she reinvested or held.
Estate considerations: Those who expect not to live a long time, or have more investments than they are likely to use in retirement, should take into consideration their estate taxes. Under current laws, there will be no capital gains tax when the securities get a new cost basis on death, so unless the funds are likely to be consumed when alive, it might be better to hold than to reinvest. The government doesn’t make this an easy decision though because paying the tax before death will reduce the estate size and therefore possible estate taxes.
Conclusions:
There may be some exceptions to my results, but I think that those retirees expecting a fairly long retirement would be wise to continue to hold both deferred-tax and taxable investments even if tax rates will go up significantly in the future. On the other hand, if I thought I had less than ten years to live and was sure of a very sharp increase in tax rates next year, I’d probably sell now at the low tax rates and reinvest—unless I would be subject to large estate taxes where I’d have to do a more refined analysis. Also, if I had high turnover taxable accounts, I’d certainly look to turn those into more efficient tax investments.
* The original issue of this paper that was dated 6/9/08 used a lower capital gains tax rate for high return investments that was not the rate stated at the top of the paper. This version corrects that.