Current Favorable Long-term Capital Gain Rates

Congress continues to discuss tax reform and whether taxes and spending should be raised or lowered. One of the topics being bantered about is whether long-term capital gain rates should be increased. Although it is difficult to say where tax rates will go in the future, we have a pretty good idea of where they will be until the end of 2012, when the current lower rates are set to expire.

The present preferential tax treatment of long-term capital gains is creating a significant planning opportunity. Clearly, for taxpayers in higher ordinary income tax brackets, shifting to investments that generate long-term capital gains rather than ordinary income should reduce taxes.

To qualify for the preferential long-term capital gain rates, the taxpayer must hold the asset for more than 12 months. The holding period generally begins the day after an asset is purchased and runs through (and includes) the date of sale. These rules must be followed exactly, because missing the required holding period by even one day prevents the taxpayer from using the preferential rates. However, the downside of holding assets (e.g., stocks) for a longer term is the risk that the price or value will fall and money will be lost on that investment.

Note that it is important to consider owning assets that generate capital gains outside of qualified (e.g., pension or profit-sharing) plans or IRAs. Distributions from those retirement accounts are almost always ordinary income, so the benefit of the lower long-term capital gain rates may be wasted.

Generally, your ordinary income assets should be held inside the qualified plan or IRA, and capital gain assets should be held directly in taxable accounts. However, a careful analysis of your investment policy is necessary to determine how to allocate investments between your qualified accounts and taxable accounts.