Many investors believe they need to make investment decisions with their tax situation in mind, and they’re often right — but not always.
There’s a phrase that goes, “Don’t let the tax tail wag the dog.” That means you should not try to optimize your investment decisions too much for taxes. My philosophy is quite simple and has done me well over the years: Invest money for growth wisely and let the taxes fall where they may.
Some tax-based stock decisions make perfect sense. For example, if you have held a stock in a taxable account for 361 days and you are thinking of selling it, I would strongly be in favor of waiting five more days to establish long-term capital gains treatment.
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If a stock is held for 365 days or longer, then you pay a lower federal capital gains tax rate. The tax for long-term gains is 20% for those in the higher income tax brackets. For short-term capital gains (on investments held less than 365 days), you will pay ordinary income tax rates — which for high earners can be as high as 39.6%. Trying to hold for long-term capital gains is certainly worth it, and would help reduce the tax bracket to 20% from what could be over 39%. This is good tax planning.
However, if you need to sell a stock to protect principal, the tax issue should really be irrelevant. Also, whenever we buy a stock, we hope we can keep it for three, five or 10 years or longer — which, of course, would be great from a tax perspective. If you do hold for 10 years, there are no taxes at all (on the gains) over this time period. Of course, once you sell the stock, taxes will be due.
I’m a staunch advocate of investing in growth stocks, which have a lifecycle. Once you have determined that the growth phase is over and the stock has principal risk, then you must act to protect principal, and the only way to do that is to sell.
Yes, you will have to pay a tax, and hopefully by that point it’ll be a long-term capital gains tax. However, this tax cost is simply an overall cost of growing your funds over time. I do not believe you should sell a gain in your portfolio every time you sell a loss. Some investors try to offset all gains with losses to avoid taxes, but doing so may mean you are selling a stock far too prematurely.
Finding great investments is hard work, and keeping them through their ups and downs is a worthy, but difficult goal. Don’t let the potential tax consequences lead you astray when it comes to making investment decisions.
Rob Lutts is president and chief investment officer of Cabot Wealth Management and the author of The Great Game of Business: Investing to Win.
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