Why Avoiding Capital Gains Can Sometimes Cost You More
Taxes will often keep high-net-worth investors from selling highly appreciated stocks, but that can turn a manageable capital gain into a big portfolio loss.
Who likes paying taxes? Let me see a show of hands.
OK. No one.
Still, taxes are part of investing, and sometimes the determination to avoid them can lead to a worse financial decision than simply writing the check.
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I know because I've done it.
Like many investors, I've held on to winners too long, in part because I feared paying a large capital gains tax bill. In 2021, I watched a roughly $1,500 investment in Adobe (ADBE) balloon to nearly $90,000. It was also a high-income year for me, so I decided not to take the profits.
Looking back, that feels like a mistake. Adobe shares subsequently fell dramatically from their 2021 highs. I was worried about the tax consequences of selling and, at the same time, suffered from a healthy dose of FOMO: What if I sold and the stock kept going up?
It didn't.
That experience has made me much less resistant to selling big winners in retirement.
Why is it so hard to let go of a successful investment? Maybe we become attached to the company. Maybe we like believing we're great stock pickers. Or perhaps the capital gains tax feels like an immediate, certain loss while the possibility of a future stock decline seems distant and theoretical.
For some investors, that can lead to tax paralysis: refusing to sell an appreciated investment primarily because of the tax bill, even after the position has grown far larger than makes sense for the portfolio.
When taxes become a behavioral problem
Behavioral finance helps explain why.
One phenomenon is sometimes called the tax-lock effect. An investor continues holding an asset that no longer fits his or her risk tolerance, investment thesis or desired asset allocation because selling would trigger a capital gains tax.
Then loss aversion enters the picture.
The concept, associated with psychologists Daniel Kahneman and Amos Tversky's prospect theory, holds that people tend to feel the pain of losses more strongly than the pleasure of comparable gains.
For a wealthy investor sitting on a large, appreciated position, writing a six-figure check to the IRS can feel like losing money rather than enjoying the result of a successful investment.
The potential future loss from owning too much of one stock can be harder to picture.
Jason Lilly, a financial adviser with Tenere Wealth Advisors in Hyannis, Massachusetts, sees several behavioral biases come together when clients resist trimming successful holdings.
For a wealthy investor sitting on a large, appreciated position, writing a six-figure check to the IRS can feel like losing money rather than enjoying the result of a successful investment.
Last year, he worked with a client who had about $1 million invested in Apple (AAPL). The client loved Apple products — "we are Mac people" — creating an emotional attachment to the company. Recency bias reinforced the reluctance to sell: The stock had been performing well, so why assume that would change?
Lilly approached the problem gradually. "As an adviser, my No. 1 fiduciary role is to help clients protect the downside. So that's how I frame the conversation. This client has 10,000 shares of Apple. We sold 100 shares at $290. Then the stock bumped up to $310 and an element of seller's remorse kicked in."
Lilly reminded the client that those 100 shares represented only about 1% of the Apple position.
"I continue to underscore the importance of having a highly diversified portfolio and a comprehensive financial plan. When I can get clients to truly see the big picture and look 10 years down the road, then they get more comfortable paying capital gains taxes," Lilly says.
For clients like these, Lilly and his team can also establish a capital gains budget for the next one to three years. Rather than treating every taxable sale as an unpleasant surprise, the investor decides in advance how much in gains he or she is comfortable realizing. So taxes become part of the plan.
When you may need a CPA
Tax planning for wealthy retirees can quickly get complicated.
Financial advisers increasingly use tax-planning software to model strategies, but an adviser generally is not a CPA or licensed tax professional. For higher-net-worth families, coordination among the financial adviser, CPA and estate-planning attorney can become increasingly valuable.
Some investors may benefit from engaging a CPA specifically for long-range tax planning. John Barut, CPA and owner of Providence Consulting CPA, PLLC in Charlotte, North Carolina, offers retirement tax planning for clients who want to estimate what their tax burden could look like five, 10 or even 25 years into retirement.
The exercise can incorporate stress testing the impact of Roth conversions, charitable giving, Social Security claiming decisions, required minimum distributions (RMDs) and tax-bracket management on the portfolio over time. Instead of evaluating each decision separately, the idea is to see how the pieces interact over decades.
Barut recently worked with a retired married couple in their 50s who had approximately $7 million in traditional IRA assets. Doing nothing with those accounts for the next 10 to 15 years could mean substantial required minimum distributions later in retirement. He developed a multiyear Roth-conversion strategy. This year, the couple plans to convert $250,000 from traditional IRA assets to a Roth IRA — and willingly pay the associated income tax now.
"This couple may live another 40 or 50 years and have to pay taxes every year on portfolio gains. But with an aggressive Roth conversion strategy, we can demonstrate how this couple can reduce their total tax burden by approximately $12 million over their lifetime. That's a significant savings," Barut says.
The exact result of any Roth strategy depends heavily on future tax rates, investment returns, longevity and other assumptions. But the larger lesson applies to many retirees: Sometimes paying taxes today can improve the long-term plan.
The hidden risk may be the stock, not the tax
Jamie Botsko, a senior family office wealth adviser at Greenleaf Trust in Grand Rapids, Michigan, works with wealthy families that have highly concentrated stock positions.
"HNW clients often misconstrue capital gains taxes as the primary risk when selling appreciated assets, when the actual risk is market decline and potential wipeout of their holdings because of a concentrated position," Botsko says.
Consider an investor with several million dollars tied up in the stock of one company. Perhaps the shares came from decades of executive compensation, an early investment in the business or ownership of a company that later went public.
The investor may have an extremely low cost basis. Selling creates a large taxable gain. Doing nothing, however, leaves a substantial portion of the investor's retirement wealth dependent on the fortunes of one company.
For clients with significant concentrated positions, Botsko may consider strategies such as charitable remainder trusts, exchange funds, variable prepaid forwards and long-short strategies, depending on the investor's circumstances.
"The key issue is not the tax hit itself, but rather the market risk that could derail clients' retirement plans. Proper planning should focus on diversification rather than tax avoidance," Botsko says.
Selling creates a large taxable gain. Doing nothing, however, leaves a substantial portion of the investor's retirement wealth dependent on the fortunes of one company.
A charitable remainder trust, for example, can allow someone with highly appreciated assets and charitable intentions to contribute those assets to an irrevocable trust. The trust may sell the assets and reinvest the proceeds without immediately triggering capital gains tax at the trust level. The donor or another beneficiary receives payments according to the trust terms, with taxes generally recognized as distributions are received. The remaining assets eventually pass to the designated charity.
An exchange fund takes a different approach. Investors contribute concentrated shares to a pooled fund containing stocks provided by other investors. In return, they gain exposure to a more diversified portfolio without immediately selling the original shares and realizing the gain. These vehicles can carry substantial restrictions, costs and complexity, so they aren't appropriate for everyone.
Other strategies, according to Botsko, including prepaid variable forwards and certain long-short approaches, can be even more complicated and typically require specialized tax, legal and investment advice.
"The goal isn't necessarily to eliminate taxes. It's to keep taxes from dictating the entire investment strategy," says Botsko.
Give yourself permission to enjoy your wealth
There is another side to tax paralysis that often emerges in retirement: Some investors become so reluctant to realize gains that they hesitate to spend money they can comfortably afford to spend.
Jason Dall'Acqua of Crest Wealth Advisors in Annapolis, Maryland, sees this with clients who have spent their working lives saving and investing.
The fear of not having enough can be healthy. It encourages saving, investing and planning. But habits built over 30 or 40 years don't disappear when someone retires.
Dall'Acqua recalls one client who takes an expensive family vacation each year but still wants reassurance that the expense is affordable, despite having sufficient assets. "An emerging part of my role is to help clients enjoy their wealth through meaningful experiences while addressing their concerns about spending," Dall'Acqua says.
Sometimes that means selling appreciated investments and paying taxes. No one enjoys doing that. But the purpose of accumulating wealth isn't simply to preserve every dollar indefinitely. Retirement portfolios are ultimately there to support your retirement, he says.
Lilly tells clients to view a capital gains tax bill from a different perspective. "This is a ‘good' problem to have. Think ahead. Be proactive. We appeal to clients' qualms about paying taxes on concentrated stock positions by using patience and framing the conversation around strategies like capital gains budgets, charitable giving, and gifting appreciated assets to manage taxes effectively."
Barut makes a similar case for looking ahead. "Having a better handle on future taxes — which many retirees don't plan for in their retirement budget — takes some of the uncertainty out of retirement planning. No one enjoys paying taxes, but showing clients their current and future tax burden makes them more open to tax mitigation strategies like Roth conversions and charitable giving," he says.
There may be one final psychological hurdle worth clearing: A capital gains tax bill usually exists because an investment made money. The true challenge is deciding when and how to pay some tax today to help protect the wealth you'll need tomorrow.
Related content
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