Year end tax planning and general planning for the New Year comes up around this time of year for many people but I believe that there possibly may be a little more emphasis placed on it this year than in most past years. The reason of course is because of all of the uncertainty around what will happen with tax rates in the New Year.
Typically planning for the next year can be done in the fourth quarter of the current year with a relative amount of certainty when we are in a stable economic environment. Getting current year tax records together and projecting business, personal and investment growth for the New Year is relatively easy however this year is a bit different. The challenge really comes down to knowing if one should consider booking profits before the end of the year and carrying losses into next year or not. Normally a big part of yearend tax planning is taking investment or trading losses before the end of the current year that will offset the current years income but if tax rates increase next year, if we fall off of the fiscal cliff, would we be better off waiting to take any losses that we may have until next year so we can offset them against gains that may be taxed at a higher rate than what they are taxed at this year.
Booking a profit now instead of waiting until next year may also make some sense because if there is no agreement in Washington around an extension of the Bush tax cuts our gains will likely be taxed at a greater rate next year than they are now. The dilemma, aside from knowing with certainty at this point what will actually happen with regard to tax rates, is knowing if it is better to let the profitable investments that are in a portfolio continue to grow in hopes that the growth will more than offset any potential tax increase or liquidate now and book a profit that may be taxed at a lower rate. The added problem around this decision of course is what will happen to those investments if our government does not reach an agreement on the tax issue. If there is no agreement how will the markets react; will it be worth taking the chance that the markets can recover a potential drop due to a negative reaction if there is no agreement or will it be a long downward slope for the markets that cannot be recovered in a relatively short period of time.
Conversely if there is an agreement will we see a euphoric market that increases rapidly making it far better to enjoy the increase in our profitable investments with no real regard to when they may be liquidated because we will then be in a relatively stable tax environment very likely at rates that are similar to today’s rates.
Possibly the worst thing that can happen is that there is no agreement by the last business day of this year with no real indication of what will happen in the future. The reason of course is if we do reach the end of the year with no agreement which direction do you go in with your investments? Do you keep everything in place as it is at that point in hopes of an agreement being reached early in 2013 with retroactive tax cuts back to the beginning of the year? This is not something that can be known or planned for this year but it certainly is a possibility. If there is no agreement reached by the end of this year everyone will need to make their own decision regarding if it is better to book their profit this year and carry any losing positions forward versus taking a loss this year and carrying the profitable positions forward. I heard a news story today that stated that a recently signed major league baseball free agent will take his $10M signing bonus before the end of this year due to all of the economic uncertainty. This is probably a good idea because the likely scenario for high earners is that regardless of what happens their income will be taxed more.