A few years ago, near the stock market top, I was talking with a frustrated financial advisor. He had a wealthy client who would not let the advisor sell the client’s large position in a major stock. The investor bought the position many years ago, held it through thick and thin, and had a large paper gain. He didn’t want to pay the capital gains taxes.
I suggested the advisor point out that the maximum capital gains tax at the time would be 20% and would be imposed only on the gain, not on the full market value. The market risk and company risk were much higher, because the stock easily could decline more than 20%.
As we know now, that market risk was realized. The investor saw the position decline by more than 20%, and it still is not back to its peak value. He would have more wealth now – and a more stable portfolio – if he had sold most of the stock, paid the capital gains tax, and diversified his portfolio into value stock funds, bonds, real estate investment trusts, and our other recommended investments over the past few years.
The point is we shouldn’t let the tax code dictate our investment decisions. Instead, integrate the tax code with both market conditions and the valuations of your portfolio holdings. Take the actions that are likely to result in the highest after-tax return.
Now is the time of year when this type of analysis is most critical. In the last quarter of the year, investors do their end-of-year tax planning, making portfolio adjustments with the year’s tax returns in mind. The key is to be sure the tax moves make investment sense.
Here are my guidelines for making shrewd investment tax moves.
Take those losses. Investment losses are painful. A number of studies show that investors experience a lot of pain from taking a loss of any amount. They’d rather hold on and retain the hope of getting their initial investment back, no matter how long it takes.
Instead, try making a fresh, objective review of the investment. If you didn’t already own it, would you buy it today instead of the alternatives available? What kind of return do you expect from it over the next one to three years? Push your emotions aside and look at the facts. Consider the most likely scenarios, not a best case or what you hope will happen.
If you wouldn’t buy the investment today, sell it.
The loss will offset any capital gains you have taken this year. Losses exceeding the year’s gains can be deducted against up to $3,000 of other income. Any additional losses can be carried forward to future years in the same way until they are exhausted.
You will get the maximum after-tax return by selling a stagnant investment, using the loss to shelter other income, and investing the sale proceeds into a higher-returning investment.
When to harvest gains. The same studies that show investors will avoid taking losses, also show that investors take gains quickly. Most investors sell when an investment first earns a modest return. They want to preserve that return and avoid the risk that it will disappear. Often, they leave a lot of money on the table by selling a good investment too soon. They don’t let an investment run its cycle and don’t have a clear sell policy when investments are purchased.
Another disadvantage of selling too soon is that higher taxes are imposed. Selling after holding an investment for one year or less means the gains are taxed as ordinary income instead of as long-term capital gains. After the 2003 tax law, that could mean the difference between a 35% tax rate and a 15% rate.
Here is some simple math that can help you decide when it makes sense to sell an investment from a taxable account.
If you sell, you are guaranteed to incur a loss equal to the taxes imposed. Suppose you have an investment worth $10,000 with a tax basis of $8,000, for a taxable gain of $2,000. If long-term capital gains taxes are due, the total tax is $300 (15% of $2,000). That is 3% of the $10,000 value. So, selling automatically incurs a 3% loss in your wealth. The ordinary income tax would be $700, or 7% of the investment’s value.
You should considering selling if you believe there is a strong probability of a market loss from holding the investment that is likely to exceed the tax loss from selling. If the investment appears overvalued or is likely near the end of the rising part of its cycle and it is not a long-term core investment, consider selling and paying the taxes.
Suppose you aren’t sure about the market outlook for the investment. Then, consider setting a sell signal, as I do for some of our Managed Portfolio investments.
Decide how much of a market loss from the peak you are willing to incur. A good range to consider is 3% to 10% below the peak price. Follow the investment’s price and sell whenever the price falls below the sell price. When selecting your sell price, remember that you will incur both the market loss and the tax loss on the sale.
Another way to do the analysis is to consider the investment alternatives and what you could earn from them. Make a move only if the new investment, after taxes, will increase your after-tax wealth. Here’s one way to do the analysis.
Suppose you identify an undervalued investment that you believe is likely to appreciate significantly. You own an existing investment worth $10,000 you expect will earn about 5% annually. If you sell, it will incur a 3% tax on its value. Does it make sense to sell, pay the tax, and buy the new investment?
The current investment would be worth $10,500 after one year and $11,025 after two years. If you sold that investment, you would have $9,700 to invest after taxes. The new investment would have to earn 8.25% the first year just to keep your wealth even with what you would have had from holding the current investment. After two years you would need a 13.66% total return from the new investment to stay even.
The required returns would be even higher if you owed ordinary income taxes on the sale.
You shouldn’t sell the current investment to buy the new one unless you expect the new investment will earn enough to keep the portfolio’s value, after taxes, at least even with what you expect from simply holding the old investment. In other words, the new investment should have a high enough return to overcome the tax loss plus the expected return of the old investment.
Your goal in every investment decision should be to maximize after-tax wealth at the risk level you are willing to take. To achieve that goal, coordinate the tax code with the outlook for the investment markets. When doing your year-end tax planning, make a few simple calculations to ensure your actions will maximize after-tax wealth.