There are a few folks I’ve been speaking with over the last couple months that are interested in working with me but are hesitant to move forward because they don’t want to sell any investments. This is largely due to the large capital gains they have embedded in some of their long-held investment positions.
Before I discuss the potential problem with this line of thinking let me express that (1) I am very sensitive to taxes when managing portfolios and (2) I do manage around concentrated positions with large capital gains when appropriate using a variety of methods (e.g. options strategies).
The problem with this line of thinking is that you’re letting the tax tail wag the investment dog. The best way to illustrate what I’m talking about is with a simple example.
Let’s say you bought a mutual fund XYZ for $500,000 a decade ago and now that position is worth $1,000,000. This implies you have $500,000 of long-term capital gains embedded in that position. If you sell the position you will realize the gain and pay 15% long-term capital gains tax rate on the $500,000 of gains ($75,000 of taxes). Net of tax, this leaves you with $925,000 of net proceeds. Obviously, paying $75,000 of tax isn’t ideal. But what’s the alternative? Holding the position only to have to sell it in the future anyway? After all, deferring the sale doesn’t avoid the tax but merely delays it.
Sidenote: If you’re planning on making charitable gifts or gifts to family and friends, I would suggest gifting shares of highly-appreciated securities (such as our hypothetical XYZ mutual fund in the example) in-kind so that you can avoid the capital gains tax altogether. But if you’re not planning on making those gifts, or if there will be shares left over, you still must address the position if it’s no longer appropriate for your circumstances.
Additionally, current law allows beneficiaries of an estate to receive a stepped-up basis, which would also address the gain issue.
The cost of selling the position and incurring the capital gains tax is 7.5% ($75,000 / $1,000,000). But, what if the market drops 10% like it did in October? In that case, the position declines to $900,000 from $1,000,000 AND you still have $400,000 of capital gains left embedded in the position! At a 15% capital gains rate that implies $60,000 of tax (15% of $400,000) so deduct that amount from the new value of $900,000 and now you’re left with just $840,000 compared to $925,000. Waiting actually cost an additional $85,000!
You lose 100 cents of each one dollar of loss but pay only 15 cents of each dollar of capital gain realized. So waiting, assuming the position is not appropriate for your portfolio, doesn’t help you at all. After all, the tax liability is still on your balance sheet even if you don’t sell at this moment. You’re not avoiding the tax but simply deferring it to the future, AND you run the risk of holding a position that may not be appropriate for your unique circumstances. October was a great example of how letting the tax tail wag the investment dog is not a good idea especially since the hottest stocks (tech stocks) were hit the hardest as some of those are now down over 30% from their peaks!
This is not hypothetical. Over the summer I began working with a couple new households for whom I had to sell stock positions and realize capital gains. Even though the sales produced taxable events, we saved significant sums of money as a result of losses that were avoided over the last two months. Additionally, the adjustments increased their probability of becoming and remaining financially independent and THAT’s the point of it all, right?
We always want to be sensitive to taxes, but we don’t want to let taxes force us to maintain positions that may no longer be appropriate for the current market environment or our current situation (e.g. proximity to retirement). After all, the next two years will likely look very different than the last two years. This means the things that worked well over the last two years probably won’t work as well over the next two years and vice versa.