Ted Allrich is the founder of The Online Investor and author of the just released book: Comfort Zone Investing: Build Wealth And Sleep Well At Night. In this weekly column, he'll offer advice to investors who are just getting started.
I recently had lunch with a very smart businessman. He was sharing some of his investing thoughts when he said, "I hate to pay taxes on capital gains. But I can't tell you how many times I've waited for my stock to reach long term capital gains status, and before it does, it tanks and all my profits are gone." I suggested he was letting the tail wag the dog.
Taxes are awful. They hurt every time you write the check. But they're as much a part of investing as dividends or stock splits or losses. They're a fact of life, you know, like death. There's no way around them in the stock market as there is in the commercial real estate market where you can do a 1041 exchange and postpone taxes. When you sell a stock for a profit, you have to pay taxes on the gain. If you hold it less than a year, you'll pay at your income tax rate. If you hold a stock longer than a year and have a gain, you'll pay 24% on the gain. The only relief is if you have losses in other stocks you sell or have sold to deduct from those gains.
There are a couple of ways to ease the tax pain. First is just an attitude change. Think of taxes as a compliment to your intelligence. You were smart enough to make a profit on your investment. That doesn't happen every time you buy a stock so you've done well and should feel good about it.
Second: face reality. You know you'll pay taxes. What you don't know is what your stock will do. You may take a gamble if your long term gains rate begins in a few days, but any longer than a few weeks is really gambling with your profits. If bad news hits your stock the day before your long term tax rate is effective, it doesn't matter how much profit you had. You won't have it anymore. That bad news could wipe out most or all of your profits in a matter of days, sometimes minutes.
Of course, you can argue that if you hold a stock through bad news, it may recover all your profits. Then you'll have to only pay long-term gains tax. That's a big assumption. The stock may have really bad news such as fraud or accounting problems or management shake up or new competition with better products. There are any number of events that would be hard to overcome. If you've lost your profits because of the event, you may never see the stock recover.
Third: do a mental calculation every time you look at your portfolio. Any profits you have, deduct 25% from them (rounding to make the math easier). That way you'll have the "true" value of those profits. If you do this long enough, you become accustomed to the new numbers and actually selling the stock is a lot easier. Writing the check may be, too.
Hoping that nothing bad happens to your stock shortly before you have a long term capital gain or even holding it just because you have a very low cost basis doesn't maximize your investing dollars. One friend said he held a lot of IBM from a long time ago. After many splits, his cost basis was 25 cents. He had thousands of shares and was determined not to sell any because he would have to pay exorbitant taxes. While he didn't pay the taxes, his net worth kept slipping lower and lower as IBM peaked and lost its luster. His loss is much more than the 24% tax he would have paid had he taken profits and reinvested in another stock.
The only way to avoid taxes is to never sell a stock. If you've found a great stock that keeps going higher and pays a dividend, there's no reason to sell it. But those are few and far between. If you aren't lucky enough to own one of those, make sure you sell your stocks when you determine they are most likely fully valued. Then pay the taxes. To do otherwise is dangerous to your wealth.
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