Why Take Capital Gains & Pay Income Taxes?
Why Take Capital Gains and Pay Income Taxes?
by Stan Corey
One of the most challenging investment decisions is when to sell a position such as a stock, bond, or a mutual fund. It does not really matter if you are selling all of the position or just a part of it. The issue is that the sale will create a taxable event if it’s not held within a retirement account.
Consider the following situation: you own a personal after-tax stock investment that you bought for $100,000 in 2012. It has paid accumulated dividends of $20,000 through 2018 and has a current value of $250,000. This single investment now represents about 25 percent of your overall portfolio. Would you consider selling all or a portion of this investment or do you want to continue to hold it? How do you make the decision?
Here is the dilemma: you have earned about a 10-percent annual return and like the investment. Nevertheless, your adviser tells you that this position is now too large a percentage of your overall portfolio value. This has increased your risk significantly, so your adviser wants you to sell half of it. You are concerned that selling half will cause you to incur federal income taxes of about $13,000 and, in the case of Virginia, where I live, $3,250 for state income taxes—a total of $16,250. That is a big tax hit. What would you do in this situation—take the advice or continue to hold the investment?
There are two ways to think about this. First, if the stock dropped in value by just 7 percent you would have lost more than the tax cost of selling half the position. And if you afterwards decided to sell that half, you would still pay income taxes of over $14,000!
Second, emotionally it is always easier to buy than to sell. So, let’s turn this into a buying decision instead of a selling decision. 
When you bought the stock, you had certain beliefs or reasons for doing so. I always suggest people write down the reasons behind making a particular investment so they can revisit it later to see if the reasoning still holds up. In this case you would need to evaluate the stock again as if you were considering buying it the first time. What are the pros and cons of making the investment? If, after this review, you determine that you would still buy the stock, then you might want to continue to hold it or even buy more. If, on the other hand, your review suggests that you would not buy it at this time, for whatever reason, then maybe you should sell a portion or even all of it.
Here is another thought: is it easier to sell a stock at a loss or at a gain?
Again, our emotions play a role in this situation. Human nature is subjective, so it is hard for us to make a truly objective decision. We tend to think that when the markets are going up, they will continue to go up, and if markets are going down, they will continue to go down (we call this “recency bias.” See my previous article). So, when it comes to our own investments, our emotions can lead us to hold onto investments too long on either the up or down side. In the situation of a stock losing value, the tendency is to believe that it will go back up so we will not have to admit we may have made a poor decision about buying the stock in the first place. That will last until the pain is too great, and we finally cave in and sell. Of course, that is just the time that the markets are about to hit bottom and begin moving back up again!
Lastly, just remember that the stock you own and have fallen in love with is not the only stock out there and that there may be other opportunities to obtain better returns if you are willing to capture some gains or take a loss.
Photo credits by: Motleyfool.com and Edward Jones
