Sell Now To Save Clients Later

As the Dow Jones Industrial Average blasted to record highs recently, everyone but the short-sellers celebrated the accomplishment. While the day-traders danced amid confetti, older shareholders with a longer-term relationship to their stocks quietly reveled in the fact that their buy-and-never-sell philosophy had largely been validated, once again.

But many of those investors don't realize the underlying risk those burgeoning positions might add to their portfolios. And even those who are thinking about reducing exposure to that risk are erroneously afraid of the damage capital gains taxes might do. Here's why scaling back the blue-chip holdings of retiring clients now could save them a lot of pain later.

Selling In 2007

At the federal level, short-term capital gains (defined as positions held one year or less) are typically taxed at ordinary income rates. But long-term capital gains tax rates top out at much lower percentages than the ordinary income tax brackets.

For 2007, long-term capital gains are taxed at just 5 percent at the federal level for taxpayers in the 15-percent bracket or below. Taxpayers in the 25-percent and higher brackets still only pay a 15-percent federal tax on long-term capital gains.

Say you have an older couple with no income other than $40,000 of taxable interest this year. They could realize $20,000 in long-term gains before the end of the year, and the most Uncle Sam would ding them on the transaction would be $1,000. Let's say that those gains are on 1,000 shares of stock currently worth $25 per share, and that the stocks were purchased for $5 per share long ago. In this scenario, it would only take a drop in price to $24 per share before the paper loss of those who hang on exceeds the taxes paid by those who decided to sell.

Great In ‘08

Although the current capital gains tax rate is good for lower-income long-term investors, it gets even better after the first of the year. That's when the federal tax rate paid on long-term capital gains by those in the 15-percent marginal tax bracket or lower drops to zero. That's right, nada, zilch, jack.

Those in the higher-income brackets will still be taxed at 15 percent on long-term gains. And both rates are scheduled to stay that way for 2009 and 2010. But in 2011, the federal rates are scheduled to return to 10 percent for taxpayers in the lower brackets, and 20 percent for those in the higher brackets. Congress could extend the little-or-nothing tax rates past 2011, but they can also raise the rates back near the 28-percent level of 10 years ago.

What To Do With The Money

Clients who love their long-term holdings, but recognize this window of opportunity, might choose to wait until 2008, and then sell whatever qualifies for the zero tax rate. As long as they wait at least 30 days to avoid wash-sale rules, they can repurchase the shares, and then benefit from the flexibility provided by the much-higher cost basis.

But many older clients will recognize a need for added stability, income, and diversification in their portfolios, and will decide that the net proceeds of their stock sales should be redeployed to bonds or bond mutual funds.

Warnings

Before you go off entering sell tickets on behalf of willing clients, there are a few things you should understand about capital gains taxation in general, and how a big dose of gains can affect retirees

Although capital gains tax rates are lower than income tax rates, realized capital gains are added to income for the purpose of calculating such things as deduction eligibility. Big profits can “phase” your clients out of deductions they might otherwise get.

Also, many retirees in the lower tax brackets currently avoid taxation on their Social Security payments, and they like it that way. But again, the sale of the stock positions can make a portion of those monthly checks taxable.

A Tax Talk

You can check your clients' potential tax liability on your own with the cursory calculator available at: http://www.hrblock.com/taxes/tax_calculators/index.html.

But it would be more sensible (and involve less work for you) to contact your clients' CPAs to discuss your selling suggestions. Better yet, arrange a meeting between the three parties involved to go over this year's tax situation.

The time to make the call, though, is now. In a few weeks the opportunity to sell during this tax year will be lost, and the CPA will be preoccupied with preparing 2007 tax returns. And the longer your clients wait to sell, the more likely it may be that the stock market party could officially come to an end.

Writer's BIO: Kevin McKinley CFP is a Vice President-Private Wealth Management at Robert W. Baird & Co., and the author of the book Make Your Kid a Millionaire (Simon & Schuster). You can reach him at [email protected]

IS THE THREAT UNCLE SAM OR MR. MARKET?

To determine if the bigger hazard to a client's wealth is capital gains taxes or a fall in share price, take the capital gains divided by the total value of the position, then multiply that amount by the capital gains tax rate. The resulting figure is how much the stock price would have to decline before the loss would exceed the taxes paid.

If your clients have 1,000 shares of a long-term stock position with a cost basis of $5,000 and that's currently at $25 per share, here is how much loss would be needed in the “held” stock to equal the taxes paid on a sale: