(MoneyWatch) As President Obama and Congress battle over a raft of mandated government spending cuts and tax hikes scheduled to take effect in 2013, there is a good chance the capital gains tax rate is going up next year. The prospect presents the dilemma of whether investors should sell today and recognize the gain at a 15 percent rate, or wait and pay a higher rate years later.
Though selling now may seem like the the obvious choice, the obvious answer is often wrong. It may pay to hold on to your gain. Here's why.
Let's say you bought a stock for $1,000, and several years later it's worth has climbed to $1,500. If you sell it this year, you'd pay a 15 percent long-term capital gains tax, which amounts here to $75, and be left with $1,425. If you waited until Jan. 1, 2013, to sell the stock and the tax rate rose to 20 percent, you'd owe the IRS $100 and be left with only $1,400.
Holding on to the stock for a few years changes the equation. That's because you can earn a return on the total $1,500 rather than only $1,425. Think of it as a loan from the IRS in return for paying a higher rate later.
If, for example, you expect your stock to appreciate 10 percent annually, you'd end up with $2,133 if you held on to the stock for five years and then paid the 20 percent tax rate. But selling it today, paying a 15 percent tax and then earning 10 percent annually, you'd end up with only $2,121 in after-tax dollars, taking into account the second gain. Thus, you are better off paying the higher rate later than the lower rate sooner.
How long you must hold on to the stock to be better off depends on the annual return you get. A 10 percent annual return breaks even in 3.6 years, but it takes 7.1 years if your annual return drops to 5 percent. If you only expect a 2 percent return, it will take 17.6 years.
In deciding whether you should sell or hold, the chart below can be a guide.
As the "fiscal cliff" wrangling continues in Washington, capital gains taxes are currently slated to rise to 20 percent (and from zero to 10 percent for lower-income earners).
But the tax talks remain fluid, and the capital gains hike is not assured. Congress could still to decide to extend some or all of the Bush-era tax cuts scheduled to expire at year-end, including the capital gains provisions. Then there's also the possibility that you may pay 23.8 percent if you are hit with the new Medicare taxes. Finally, proposed changes to the alternative minimum tax can further complicate things.
I've always said investing is simple, but I've never said taxes were.