When It’s Smart to Pay Capital Gains Taxes

When It’s Smart to Pay Capital Gains Taxes

Had to include a stadium of an actual playoff team. Sorry Pittsburgh.

Imagine for a moment that you are the coach of a Major League Baseball team and you’ve successfully coached your team to the World Series. You’re about to start the 9th inning of Game 7 and your team is up 3-1. You are just three outs away from being crowned World Champions. A life-changing opportunity for players and coaches alike.

But before the 9th inning begins, you visit the opposing team’s dugout and ask their coach if they’d like to extend the game by three additional innings.

Obviously insane, right? Rules aside, no coach would ever do that. We don’t even do that in our Sunday night pickup basketball games.

Yet this is exactly how many investors approach capital gains – particularly when they have a huge gain in an individual stock they’ve held onto for years. As the position has grown, it has become an ever-larger piece of their portfolio and as a direct result, an unnecessary risk to their retirement goals.

Even after their total portfolio value has approached the level they need to retire, instead of selling, they want to hang on to it.

Why? Because they’ll have to pay “too much in taxes” to sell it.[1] “Let’s wait and see what happens” is a popular refrain.

Wait and see?! What?!

There are only three possible outcomes that can accompany this “wait and see” approach:

  1. The stock price doesn’t move so they are no better or worse off theoretically (ignoring opportunity cost).
  2. The stock price rises and exacerbates the capital gains issue they are seeking to avoid.
  3. The stock price falls reducing the gain and the taxes that go along with it.

What exactly is the investor hoping will happen? Wasn’t the whole point of investing to make money? If they’re at the doorstep of achieving their retirement goals, why keep playing the game?! Are they hoping the stock falls in value so they could pay 15-24 cents less for each dollar they lost? Crazy, no?

Even if everything stays the same, at some point – if they ever want to actually use the money – they will have to sell and the tax will have to be paid.

For the record, I understand there are certain circumstances (Medicare IRMAA, waiting for a step-up in basis, moving to a state with a lower tax bracket, etc.) where it might make sense to wait and/or take other specific measures to protect their gain while reducing their position, but these situations are rare.[2]

I see the situation I’m describing above far too often than makes logical sense. It’s why I’m confident it’s the avoidance of taxes that is driving the bus. But if you let taxes drive investment decisions, at some point the bus crashes.

Ironically, even when you look at the math, refusing to sell for tax avoidance purposes makes little sense. Let’s say you have a $200,000 investment with an embedded $100,000 capital gain which you are continuing to defer. And let’s assume you are in the top tax bracket making your long-term capital gains rate 23.8% (20% plus 3.8% Medicare surtax).

If you sell the position in its entirety, you will pay a tax of $23,800 all things being equal. This is 11.9% of the total value of the investment. On the whole, this is equal to a very small amount of overall downside volatility as we regularly see individual stocks lose 5% or more in price fluctuation on any one day, much less over longer periods of time.

Even excluding the individual company risk, a typical intra-year market decline of about 15% means you would have likely experienced that level of downside at some point through the year anyway.

But in this case, by selling, you reduce your unsystematic risk by reinvesting those proceeds into a more prudent portfolio allocation.

Choosing not to sell is a little bit like picking up nickels in front of a steamroller in that the reward is not worth the risk.

I certainly understand people wanting to exit positions in a tax-efficient manner, but if this is you and you have already reached your goals, I have a pair of questions that are worth asking.

  1. What’s the risk if you sell?
  2. What’s the risk if you don’t sell?

I’ll save you the effort. If you sell, you give up the opportunity to make even more money on something that has, in all likelihood, helped you reach your goals faster than you would have otherwise. And second, you’ll get hit with the taxes that come along with making money in our capitalist society. Instead of looking at this as a negative, consider this: You won the game. This was the goal from the start.

On the other side, if you don’t sell, and this position makes up any significant portion of your net worth, you run the very real risk of materially impacting the next few decades of your life. Think about all the folks that have hung on to their GE stock these past few years.

This Reddit thread comes to mind (from two years ago – eek!):

Reddit Thread

I’ll ask it another way.

Is the potential reward of a concentrated position worth the risk?

That’s for you to decide.

[1] This argument seems to hold true for people with huge individual stock positions in IRA/401k accounts as well (where capital gains taxes are irrelevant), though to a lesser extent. Investors will still hang on to it thinking it will just keep doing what it’s always done. But my argument is the same: Theoretically, if you’ve already won the game, why keep playing?

[2] There are situations where maintaining these concentrated positions makes sense. This post is not an end-all, be-all for this type of situation as there are special circumstances that can arise to render these arguments moot, but I believe these are very few and far between.

**This post is not investment, tax or legal advice. Please see additional disclaimers.

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