Capital Gains Tax Trap

February 07, 2023

Many of us own securities outside of our retirement accounts. Those investments are exposed to tax implications throughout their existence. Things like dividend income, interest payments, and realized capital gain can all generate tax liabilities that can drag down the performance of the account, as funds are distributed to pay taxes.

Sometimes, though, the fear of taxes can cause an account to miss out on performance opportunity. Tax management is important for sure, but it should come as a clear second priority behind overall performance. Too often, investors are afraid to sell a security because of the potential tax bill even if that security doesn’t have a tremendously positive outlook for the future.

Let’s draw a hypothetical example.

Jim owns a stock. He has a $100,000 taxable gain in that stock. If he were to sell it, he would pay 15% on that gain, or $15,000. So, if Jim sold his stock, he would profit $85,000 after taxes.

This stock doesn’t have a lot of growth opportunity. It’s grown tremendously over the years and now holds a dominant position in a mature market. That just means that achieving growth in large percentages is going to be tough for this company. Analysts expect it to grow its stock price by 6% per year from here on.

Jim’s alternative is to invest in a fund that is expected to grow at an 8% rate into the future.

Here are Jim’s choices.

1. Stay with his stock that has appreciated value. Continue to keep his $100,000 gain, as it’s not taxable until he sells the stock. Let it grow at 6%.

2. Sell the stock, pay taxes, and have $85,000 left over to invest into the fund at 8%.

If Jim sells the stock and buys the 8% fund, it takes 9 years for that fund to outperform the stock. While his account suffered from a $15,000 tax bill that had to be paid, the better performing fund eventually made up for the taxes and passed the 6% stock in overall value.

What’s the moral of this story? Don’t make investment choices solely on tax management. It’s smart to pay attention to taxes when making decisions, but performance over time is more important. Buy good investments that appreciate value. If those investments lose some of their earning potential, it can be smart to replace them even if it can cause a taxable event.

This content includes only hypothetical examples and is not representative of any specific investment. Your results may vary.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.