Learn about the dos and don’ts of taking profits.
As I settled into a favorite fall season routine of watching college football, my thoughts began to drift in a very different direction toward personal finances and the current stock market environment. This isn’t all that unusual considering that I’m in the investment business – and that my team was losing!
Most if not all investors are fully aware that global equity markets have appreciated significantly since the market bottom of March 23rd, 2020 that coincided with the first major wave of the coronavirus. Since that date through the time of writing this column, the S&P 500 Index as well as many other benchmark indexes have realized double digit gains. This begs the question, “should I sell”?
First consider what the money is for
Like many investors, I have different goals for my money, long-term and shorter-term. I have no need to touch the savings in my tax-advantaged retirement account, which I have enjoyed watching rise along with the markets. But the unrealized capital gains in my taxable equity account that I am planning to use to fund my shorter-term goals are causing me a little anxiety as I think about whether to sell some investments. The goals I need to fund include the remaining college debt owed for my three daughters who recently graduated college and also paying for their future weddings.
At first glance it would seem the sensible choice would be to take some of the profit from my investments to eliminate the debt. Perhaps, I should sell a little extra to make sure I have cash on hand to pay for those weddings.
But not so fast!
Next think about all the implications of selling your appreciated investments
There are certain disadvantages to selling investments that have outperformed. These include:
1. Immediate Capital Gains Exposure:
If you hold your investments in a taxable account, you will likely owe capital gains taxes on the sale of any appreciated asset. The capital gains tax is calculated by taking the total sale price of an asset and deducting your cost basis. You will pay:
- Short-term capital gains tax on the profits on an investment you’ve held for less than a year. The tax rate will be the same as the tax you’d pay on your ordinary income, such as wages from a job.
- Long-term capital gains tax on investments you have owned for more than a year. The long-term capital gains tax rates are 0%, 15% and 20%, depending on your income. These rates are typically much lower than the ordinary income tax rate.
If your income is above a certain amount your profits also may be subject to an additional levy of 3.8%. Capital gains taxes can take a significant chunk out of profitable investments, particularly if the holding period is less than one year or if you are in a high tax bracket.
2. The Risks of Market Timing
Another thing to think about when you sell is whether you might be better off holding on to your investment over the long term. If you are worried about a potential market correction versus needing to sell, you are effectively trying to time the market, which historical data shows is hard to do effectively. You may find that you would be better off sticking to your original investment plan.
Then consider more strategic alternatives
While it is tempting to sell a large portion of winning stocks following a record-breaking rebound, in my view a tax-loss harvesting strategy is a preferable alternative.
Tax-loss harvesting is a common way to help lower your tax bill by selling a security that has lost value to offset the tax you will pay when you sell an investment that has appreciated.1 If you think that the security you are selling at a loss may appreciate in future you can replace it with a similar investment.
There are specific rules you have to follow if you want to use tax-loss harvesting and replace the investment you’ve sold. The wash sale rule prohibits claiming a loss from a security sale if you buy a substantially identical one within 30 days before or after the sale for which you are realizing the loss.
If, like me, you are considering this strategy and want to buy the replacement shares before you make the sale to realize the loss, you will need to make the purchase no later than November 30, 2021 if you want to sell on December 31, 2021—the last day you can sell in this tax year.
Tax-loss harvesting isn’t just an end-of-year strategy. Consider making it a year-long activity to help you take advantage of market swings. Contact your tax advisor for more details on this strategy.