The stock market has rallied tremendously over the past five years, leaving many investors with some very large capital gains and some large positions in a few stocks or funds. Some people are worried about losing these big gains, but wonder how they can sell without realizing significant taxes. The U.S. federal capital gains tax rate was increased by over 50% (from 15% to 23.8%) in 2013 for the highest income taxpayers. One good rule of thumb regarding tax planning is to defer paying taxes as long as you can. We believe one of the keys to building wealth over long periods of time is to minimize the “leakage” in your portfolio from investment costs and taxes. Many people realize it is smart to buy low and sell high, but selling what is up the most often involves paying the largest capital gains tax.
Buy and Hold
We believe that the best long-term investment strategy involves buying and holding quality investments. Deferring or avoiding capital gains taxes is one of the key benefits of using a buy and hold investment strategy. We believe that by minimizing trading activity ourselves, and by investing in funds that have low turnover, we can help clients avoid a significant amount of taxes over time. We try to maximize our client’s after-tax investment returns. We have developed a financial model that compares holding an investment with a large gain to selling it and paying the taxes, and reinvesting the proceeds into a different, “better” investment with hopefully higher expected future returns. If the new investment has the same future returns as the existing investment (assuming a 100% long-term gain and a 30% total capital gains tax rate), you are better off holding it rather than selling and paying the tax by 7% after 10 years, 12% after 20 years, and 18% if you hold the position until your death. The new “better” investment needs to have returns that are 0.9% per year better (over the next 10 years) than the existing investment in order to break even and recoup the money you lost by selling and paying capital gains taxes. The greater the existing capital gain percentage in your existing investment, the more it makes sense to hold onto the investment and avoid paying taxes on it.
Own High Quality Investments
One of the best ways to be confident in a buy and hold investment strategy, and avoid trading and capital gains taxes, is to invest only in high quality diversified investments that you can imagine yourself owning for 10 to 20 years or more. This way you will not feel the need to sell something just because it is up, looks overvalued, is losing its competitive edge, just reported horrible news, lost its hot streak, etc. It is likely difficult to imagine being confident in holding big positions in all of your individual risky stocks for 10 to 20+ years. We prefer investing in diversified low-cost index-based funds that own hundreds or thousands of individual securities. These are the type of funds we can imagine owning forever, allowing us to defer the taxes for a very long time. The best solution for avoiding capital gains taxes on positions with huge gains is to own them until your death, at which point the cost basis will be “stepped-up” to the value at your death, and you (and your family) will have completely avoided the taxes on the gains. The older you are, the more it makes sense to continue to hold on to investments that have huge gains.
Other Ways to Avoid Capital Gains Taxes
Gifting. Investors with big positions in stocks or funds with large gains can gift those investments directly to a charity, to a charitable trust, to a charitable donor-advised fund (DAF), or to your children or family members who have a lower tax rate than you do. Some smart people make a large charitable contribution to their donor-advised fund in the same year they experience a large taxable gain, to offset some or all of the taxes. You can front-load many years of your normal annual charitable contributions to your donor-advised fund in the same year you take the large gain, get the big tax deduction that year, and then make your charitable gifts from the donor-advised fund as usual over the next many years. Another strategy might be to sell three-fourths of the position with the big gain, and donate the other 25% to charity or to your donor-advised fund and use that charitable deduction to offset some of the capital gains tax.
Strategic Selling. Investors can use tax loss harvesting from other capital loss positions you own to offset the gains you realize by selling one with a big gain. You can also sell some of the position with a big gain in a tax year when your taxable income and tax rate take a significant drop. For many people, taxable income and tax rates drop significantly once they retire, making it less expensive from a tax point of view to sell some of their winners. This can be especially true if they move to a state with a much lower (or zero) capital gains tax rate such as Florida when you retire. It can also make sense to spread out the capital gain income (and taxes) by selling a portion of the big winning stock over several years, rather than selling it all in one year. If you are trying to reduce the overall risk or equity market exposure of your portfolio (to rebalance or reduce risk) after a big stock market increase, it may make sense to sell positions first in your tax-deferred IRA or 401K accounts, where there are no capital gains taxes created by selling your winners.
Other Strategies. Other ways to reduce, delay, or avoid capital gains taxes are using 529 college savings plans, Roth IRA’s, and 1031 exchanges (for real estate investors).
Just Sell and Pay the Tax?
Sometimes it is smart to just bite the bullet, sell some of the position with the big gains, and pay the capital gains taxes. Some investors end up with a big winner in an individual stock or fund that is now too large and risky as a percentage of their overall wealth. A concentrated position in an individual stock that is more than 10% of your portfolio is fairly risky. In this situation it may make sense to sell some of the individual stock position and pay the taxes, purely from a risk reduction point of view. When you sell one stock and pay taxes on the gain, you reinvest the proceeds into another investment that now has a higher tax cost basis (reducing your future tax exposure). Thus, in the long run you are not as far behind by selling and paying the capital gains tax as you might think. The objective of investing is to try to grow your wealth and hopefully end up with some big winners. Paying some capital gains taxes once in a while, out of your portfolio gains, is part of the game. We believe it is best to think of taxes as one of the important factors in making investment decisions, but it should not be the overriding factor. In situations where you have a big gain in an investment you are worried about, one which you can’t imaging owning for the next 10 years, which is now excessively large and risky for you, it can make sense to just sell some and pay the taxes.