THE BLOG

The Taxman Cometh

02/18/2015 11:46 am ET | Updated Apr 19, 2015

The huge increase in stock prices over the past six years has created an interesting dilemma for individual investors seeking to protect their wealth. The overall market, as measured by the S&P 500, is up over 200 percent since the March 2009 low. As a result, large unrealized capital gains lurk within the portfolios of most individual investors. The magnitude and breadth of the bull market has also resulted in a dearth of embedded losses that can be used to offset the big gains. Therefore, selling positions now would result in big tax liabilities, cutting deep into returns. Staying invested, on the other hand, could push out the tax pain indefinitely but could also result in giving back some hard-fought gains in the event of a market downturn.

Recent changes in the tax statutes (effective for the 2013 tax year) will only compound the pain of selling for investors in high tax brackets. If you're one of the fortunate ones in the highest tax bracket, for example, you could be on the hook to pay over 36 percent of your gains! Here's how the math works out. Beginning in the 2013 tax year, the federal rate for long-term capital gains went from 15 percent to 20 percent for those in the top tax bracket. In addition, the richest among us will also pay a 3.8 percent surtax to help fund Medicare. And finally, if you live in a state with a high income-tax rate, like California, you could be on the hook to pay up to an additional 12.3 percent. The sum of all these taxes would exceed 36 percent, and we aren't even including any local tax liabilities!

From my experience, making decisions based solely on tax considerations usually results in bad decisions. An article on Fidelity's web site advises us, "Don't let lowering your current-year taxes undermine a diversified investment portfolio." Indeed, taxes are just one of a number of factors that should be taken into consideration when making a decision to sell an investment. Investors also need to be mindful of other factors, including the following:

  • Will I need the money to meet living expenses or other planned expenditures over the intermediate term?
  • Are there attractive investment alternatives for my sales proceeds?
  • Is my asset allocation still in line with my long-term goals?
  • Will I have the discipline to buy stocks back if/when opportunities arise?
  • Will tax rates on capital gains continue to trend higher in the future?
  • Am I effectively "fighting the Fed" and going against a powerful upward trend by selling stocks?
  • Are my actions being driven by emotions rather than fundamentals?

Ironically, the large embedded capital gains in the stock market could be one of the factors that are supporting stock prices. These large tax liabilities could lead investors to "ask questions first and shoot later" when deciding whether or not to sell out of positions. Moreover, older investors might be more inclined to sit on gains and let their heirs benefit from a "stepped-up" basis. In other words, individual investors will have to get pretty scared before they willingly agree to pay up to 36 percent of their gains to the taxman. This is especially true given the backdrop of improving economic fundamentals, including rising consumer confidence.

We at Farr, Miller & Washington have staunchly adhered to the mantra that "nobody can effectively time the markets with any degree of consistency or precision." Triggering capital gains taxes is just one of the risks associated with market timing, but it is a very important one. Whimsically selling out of positions and paying capital gains taxes can cause dramatic damage to your portfolio's long-term performance. We would advocate a calculated approach to gain harvesting, as we're all pretty much in the same boat right now.