November 2006
Most people don't like paying taxes and will seek out ways to minimize their payments to the IRS. That is very rational behavior. I get heart palpitations every time I write the check. Unfortunately, that mindset will also carry over into the management of their taxable investment portfolios and will sometimes become the tail that wags the dog. That is, the investment merits for making a strategic change in a portfolio are overridden solely by the income tax implications. These people just don't want to pay capital gains taxes period! In our opinion, this way of thinking is a formula for mediocre investment returns over a long period of time.
Like with any expense in the investment process, effort should be made to keep the annual tax liability as low as possible so that the net returns can be as high as possible. There are some basic things that can be done to help in that endeavor.
First, it might make sense to have most of your stocks in your 401k or IRA retirement plans where there is no tax on capital gains. In taxable accounts, strategies should be used throughout the year to realize losses to offset current or future capital gains. In addition, tax-free municipal bonds and money market funds should be used in portfolios for investors in higher income tax brackets.
Ideally, investments should be held at least a year to qualify for the lower long-term federal capital gains tax rate, which is currently 15%. A short-term capital gain is considered ordinary income and is taxed at a person's marginal tax rate, which is usually significantly higher. Unfortunately in the real world there is a risk to holding on to a volatile investment like a stock after it has had a good run and is no longer a bargain. We have seen many a capital gain whither away as it waited to be taxed at the lower long-term tax rate. And depending on the size of the gain in the stock, it may not take much of a decline to be at a breakeven price where the investor is no longer better off waiting for the year anniversary.
Let's look at an example. If you purchased a stock at $20 a share and it jumped to $30 in five months you would have a 50% unrealized short-term capital gain. If the stock is fully or overvalued at $30 (using historical valuation data) there is risk that the stock could fall to a more reasonable price. However, if you do sell it now the income tax liability will be $3.50 per share (assuming a 35% federal marginal tax rate and ignoring the state tax). If you wait for the one year holding period and the stock remains at $30 and is then sold, the tax will be $1.50 (15% long-term rate) per share or 57% less. What should you do?
We always look at the breakeven price (BEP) to which the stock would have to fall to make it more beneficial to realize the short-term capital gain and pay the higher tax. The formula for computing the breakeven price is the following:
BEP = Sale Price - S.T. Tax - (Cost x L.T. Tax Rate)
1 - Long Term Tax Rate
When you do the math with the assumptions used above the breakeven price in this example is $27.64. That means that the stock would only have to fall 7.9% from $30 for the investor to be in a breakeven situation of selling now at the higher tax rate or taking the risk of waiting seven months and hoping the stock does not fall more than 7.9%. Depending on the your opinion of the valuation of the stock at $30 as well as the current stock market environment, it might make more sense to realize the short-term capital gain and lock it in. A decline of 7.9% could happen in a day.
Another consideration in the decision making process is how much upside does the stock have at $30. Again, if you assume that the stock is fully valued at $30 then by definition you would think the upside from here is limited. There may be other investment opportunities available with much more upside potential. Therefore you also have to consider the opportunity for higher returns that will be lost by waiting around for another seven months to get the long-term tax rate.
We have seen many portfolios with large concentrations of five to ten stocks (sometimes more) that had very low cost basis. These stocks had obviously been held in the portfolios for a long time. In many cases, when we analyzed the performance history of the portfolios we discovered that the investment returns were very good for a few years but then the portfolios went through a long period of stagnation as these stocks performed no better than the stock market or, in many cases, much worse.
This pattern happened in the 1970's to 1982 and then again from 2000 to today. Even though the popular, large-cap stocks (a.k.a. The Nifty Fifty) in these two time periods rose to very high valuation levels, most people with taxable portfolios that were holding them failed to maximize their returns by selling the stocks, paying the dreaded taxes, and moving on to more attractive investments. The same can be said for those investors who bought technology stocks at the right time but hung on too long to avoid paying taxes. Big mistake... Big!
We have learned over the years that to maximize investment returns, investors have to be willing to look at capital gains taxes as an expense of investing and not let their aversion to paying taxes be the prevailing factor in making smart investment choices. Theoretically, experts will argue that, over the long run, investors are better off in portfolios that make few changes and minimize capital gains taxes. Unfortunately we don't live in a theoretical world.
In the real world, stocks, like companies, have a life cycle. There is a period of fast growth where the companies are growing rapidly and their stock price increase in leaps and bounds. This is when stock valuations tend to get stretched.
After the growth spurt in the earlier years, most companies mature and their growth rates decline, sometimes dramatically. It is during this period when their stocks tend to languish. Holding on to these stocks during this timeframe to avoid paying taxes can be a sure way of watching your compounded rates of return go from exceptional to ordinary or worse. Don't be afraid to take the capital gain. We're not.
John W. Gudritz, CFA
john@frontstreet.com