Tuesday, March 20, 2007

Taxes may complicate, but you can overcome!

Jon, I practice "dollar cost averaging on steroids" in tax deferred accounts because taxes complicate things, and I prefer to keep it simple. And, I planned to avoid the issue in my blog for the same reason. But, since you asked (see comments), and with the understanding that I'm no tax expert, let me take a stab at putting some broad outlines and ideas out there.

Practicing my methods in a taxable account, particularly if done on a relatively short term basis (say, once per month), would mean several sales for each fund which would have to be accounted for at tax time. Assuming you have several different funds, this could well mean 50 or more transactions for which you would have to calculate a basis vs sales price and apply capital gains rates. And, if you are not careful, some of this could be short term gains, with relatively high tax rates. You could also run afoul of wash sale rules. Having said that, however, if you are willing to carefully plan and execute your trades and keep detailed records and do the math at tax time, working this system in a taxable account could actually be advantageous over a tax deferred account.

The reason for this is that the gains in your tax deferred account will eventually be taxed at your relatively high regular tax rate, when withdrawn. This is true, even if the gains were long term gains which would have been subject to much lower rates if they were in a taxable account. But, in a taxable account, if you are willing to plan, execute, record and calculate carefully, you can probably limit yourself mostly, if not entirely, to long term capital gains rates, which are probably about half your normal tax rates.

This is where it gets complicated. In order to accomplish the above goal, you would have to:
  • Keep precise records of every purchase and sale, including dividend reinvestments.
  • Order execution of all sales by specifying sale of specific shares purchased at specific dates at specific prices, rather than a general sale for which you would have to use the average purchase price of all shares as the basis. By doing this, you could make sure all gains were long term, and greatly limit any gains in a specific year by selling shares bought at the highest price first.

As you mentioned, you would want to avoid sales which would push you into a higher tax bracket, but long term capital gains rate scales are fairly broad, so it would be unusual to be at the precise point where you would be pushed into a higher bracket.

So, I believe, if you were willing to do the work it is possible you could work the system very effectively in a taxable account. This would be particularly true for someone who is near retirement and will be in a high tax bracket in retirement. For each particular case you would have to run the case of the years of time value of money vs any differences in tax rates today vs those you expect in retirement. I don't do it, because I don't enjoy accounting that much and because most of my assets are in retirement accounts anyway. Plus, I don't have a great deal of confidence in my ability to predict what my tax rates will be in 20 or 30 years. For me, it is better to minimize my taxes today, save all that work and hope that things work out down the road.

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