Skilled pool players aren’t thinking about the shot they are shooting. They are focused on the next two or three shots following and how to position the balls on the table so they can maintain an advantage. The same technique can be used in planning for your financial independence. Here are two quick tips for 2012.
#1: Net Unrealized Appreciation: Cost Basis Manipulation
If you own your employer’s stock in a qualified retirement plan, like a 401 (k) or ESOP, upon your termination the IRS allows you to take the stock out of the plan in kind. You have to pay tax on that distribution but here is the advantage—you only pay tax on your cost basis. Cost basis is what you actually paid for the stock. Your plan administrator is required to track that for you and can provide it to you upon request.
Here is the idea—If you work for a company whose stock fluctuates widely and your cost basis is higher than the current price, sell the stock in the plan and buy it back at the lower cost. Since it is in the plan there is to tax impact on the transaction. You now have a new cost basis that is lower. If you spin the stock out of the plan, you will pay tax on that lower amount. Note—if you are under 59.5 you will have a penalty, so do the math to make sure it works for you.
After the stock is out of the plan any gains above the new cost basis—the term is Net Unrealized Appreciation—will be treated as capital gains when you sell the stock. Capital gains rates are lower than most ordinary income tax rates now, but that could change and impact this strategy.
#2: Pay me now or pay me later—managing cost basis in highly appreciated assets.
If you have owned a stock for a while and have a significant gain you may want to consider realizing the gain in 2012 and paying the tax at current rates. The top rate for capital gains is now 15% federal. Some states have a capital gains tax on top of that. There is a lot of talk by the President and some legislators about raising the rate. If they do nothing, the current rates expire at the end of this year and go up to 28%. The only conclusion is that the rates will either stay the same or more likely will go up.
Here is the idea—sell the stock in your account, wait 30 days or more and buy it back. There is a rule prohibiting the sale and repurchase within 30 days called the “Wash Sale Rule” which is there to prohibit the manufacturing of realized losses for a tax advantage. If you have some other positions in your account that are at a loss, you can sell them too and offset the gains dollar for dollar. By selling the stock you realize the gain and will be taxed at this year’s rates. You will also establish a new cost basis for when you decide to sell later. If you have a $10,000 gain the difference between a $1500 tax and a $2800 tax is an 86% increase. I don’t know about your house, but at my house $1300 is real money.
Remember, sometimes it makes sense to pay now—not later. That’s how you line up your next shot.
By David M. Wheat, CFS, ChFC
Senior Advisor, Axiom Advisors, LLC