As the saying goes, there are two things in life that are certain: death and taxes. While nobody can permanently escape either, everyone tries their best to do so. This makes sense when it comes to dying, but it might not always make sense for paying taxes.
In the tax world, we are taught from the beginning of our careers the foundation of good tax planning is to try to defer taxes as long as possible. If you understand the time value of money, this concept makes perfect sense. The longer you can let your money grow without paying taxes, the more money you will have in the long-run.
This fundamental rule still applies, and in most cases you do want to defer paying taxes as long as you possibly can. However, there are times when you might be better off paying taxes sooner. Here are some scenarios where you might want to buck conventional wisdom and pay the government now instead of later:
Rebalancing Your Portfolio
When an investment increases in value from your purchase price, you have an unrealized capital gain that isn’t taxable until you sell the investment. Our natural desire to avoid taxes can lead us to never want to sell those investments that have increased in value. That can be a good thing, as we often stress the importance of investing for the long-term. Unfortunately, never selling can also cause your portfolio to become misaligned with your goals and risk tolerance. Throughout history, over the long-term, stocks have grown at a higher rate of return than bonds and cash. So if you never sell any of your equity investments, you’ll wind up with a more equity-oriented portfolio.
We often say you don’t want to let the “tax tail wag the investment dog”. While it’s important to weave your tax planning in with your investment management, you don’t want to let the tax consequences drive your investment decisions. You might have to pay a big tax bill to trigger the gain, but you risk losing a lot more if the value declines. Consider this example:
In 2017 you bought Boeing shares for $200. In 2019 the price hit $400, so your allocation to the stock had doubled and you think you should rebalance. You calculate you’d owe 15% Federal tax and 7% state tax on the unrealized gain of $200, or about $44 per share. You decide that’s too much to pay so you hold on to the shares. By the end of 2019, the price has dropped to $324, so you’ve lost $76 per share, much more than the taxes you saved by not selling. You think about selling now because you are still over your target allocation for Boeing stock, but you still have a gain of $124 per share that would trigger taxes of $27 per share, so you decide to hold. This year, Coronavirus hits and the share price drops all the way below $100 per share. You no longer have a tax problem because your shares have an unrealized loss instead of a gain!
There are many additional factors to consider in this analysis. Capital gains are taxed at different rates depending on your income level, so you have to understand what your current capital gains rates are and what they might be in future years. If you are older, you should also consider the step-up in basis your heirs would receive on assets they inherit. Taking gains and paying taxes isn’t always the best decision, but you shouldn’t let the existence of a tax hit prevent you from making sound investment decisions.
Tax Rates Might Go Up
You probably don’t think your tax bill is too low right now, especially if you are in the top tax bracket. But if you look back throughout history, current tax rates are quite low, especially in the top brackets:
The government is currently spending money at unprecedented levels to support the economy while we fight the COVID-19 pandemic, and it is likely not over yet. While higher levels of debt and spending don’t necessarily demand higher tax rates, it certainly wouldn’t be surprising to see tax rates increase in the future. If you think tax rates in general are bound to rise in the future, it might make sense to pay taxes now at lower rates through Roth conversions, IRA distributions, or taking capital gains.
You Are Temporarily in a Low Tax Bracket
While it’s impossible to predict what the government might do with tax rates in the future, you might have a better sense for what your own tax situation will be in the future. As an example, if you retired in your 60’s, aren’t taking money out of your IRA’s and haven’t claimed social security yet, you might be in a very low tax bracket. That could change when you claim social security and/or when you start taking required minimum distributions at age 72 from your retirement accounts. If you know that you are going to have a low income year, and that you’ll have higher income years in the future, it likely makes sense to try to pay taxes at lower rates now and to potentially minimize taxes in future years.
Your Heirs Will Be in a Higher Tax Bracket
If it’s impossible to predict what the government will do with tax rates in the future and it’s difficult to know what your own tax rate will be in the future, you couldn’t possibly be expected to consider your heirs’ tax rates in the future, could you? Unfortunately, their tax rate could very much impact your own tax planning, especially under the new SECURE Act rules that require beneficiaries to take money out of an inherited IRA in 10 years instead of over their life expectancy. Let’s consider another example:
Jane is a retired widow with $500k in an IRA and $500k in a regular investment account, She takes the minimum required distribution each year from her IRA and uses social security and distributions from her regular account to cover cash flow needs. She is in the 12% tax bracket. She has one son who will inherit all her assets and he is a doctor with income that puts him in the top tax bracket. If Jane dies, her son will have to take the full amount out of the IRA within 10 years and pay tax at his top tax rate of 37%. He will get a step up in basis for the assets in the taxable account and not owe any tax if he sells them. From a tax perspective, Jane would be better off taking more out of the IRA to maximize the lower tax brackets during her lifetime, leaving more in the taxable investment account for her son.
There are many reasons to consider your own tax planning right now. The CARES Act suspended the RMD requirement for 2020, so many individuals need to decide whether they should take a distribution this year. The decline in the stock market this year could make Roth conversions more attractive, even if that means paying tax now instead of later. Many individuals have been furloughed or laid off from jobs and could be facing a year of very low income. Maybe your income is primarily from investments and capital gains and this year you have taken capital losses that will offset much of these gains. These situations could all present a tax planning opportunity if you are fortunate enough to have the resources to cover your cash flow needs.
Conventional tax planning wisdom says to always defer taxes as long as possible, but every situation is unique. There are many factors to consider and we are here to help you look at the big picture and make decisions that align with your long-term goals. Please feel free to reach out to us if you’d like to discuss this.
-Chris Benson, CPA, PFS
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person.
Please see Additional Disclosures more information.