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Tax Considerations for Selling a Stock by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research May 10, 2007 Excerpted from the Winter 2006 issue of On Investing, a magazine for Schwab clients. Last issue, I stated that the decision whether or not to sell a stock could be encapsulated in this rule: Sell an existing holding if another stock compatible with your risk tolerance is available that provides higher return potential after subtracting any taxes and transaction costs incurred in executing the swap. This column will focus on tax considerations in making sell decisions. While capital gains taxation involves complexities beyond the scope of this column (consult an expert for details and personal tax advice), the basic elements of estimating stock sale tax impacts are straightforward. A capital gain is the difference between the proceeds from a stock sale and the original cost of acquiring the stock. The capital gains tax rate is only applicable in taxable accounts and depends on the investor's overall income tax bracket and how long the stock was held. Gains for stocks held for less than a year are taxed at the investor's marginal income tax rate, while gains from stocks held for more than a year are taxed at a reduced "long-term" rate. Capital losses offset capital gains before computing any tax obligation. Leftover losses are partially deductible, with the remainder carried over until the next year. Stock investors often seem to cluster at one end of the spectrum or the other when it comes to dealing with the tax consequences of investing. Either they practically ignore taxes in their decision making or they become obsessed with tax avoidance. Both extremes are likely to lead to suboptimal after-tax portfolio returns. Let's now outline how capital gains taxation should be factored into the decision to hold or sell a stock. 1. Remember your objective The primary goal of managing a stock portfolio is to outperform the market on an after-tax basis. To beat the market, you must systematically buy winners and sell laggards, and accept the resulting capital gains tax liabilities. 2. Stay in the present with an eye toward the future The purpose of any sell decision is to adjust your stock portfolio for greater potential future performance. In general, current holdings with weak prospects should be swapped for new stocks with better prospects. For more on this, see my article, "Considerations for Deciding When to Sell a Stock." Important: The market does not know you own a stock, which means how long you have held a stock or whether you have a gain or loss is irrelevant to that stock's future return prospects. Hanging on to a losing stock with weak prospects with the hope of breaking even later is one of the most common and damaging mistakes an investor can make. 3. Selling a winner "locks in" a gain—and a loss Another common mistake is selling a stock that still has good future prospects simply to lock in a profit. Remember, realizing a capital gain creates a tax liability that leaves you with less capital to reinvest. That's okay only if the prospects for your next investment are far superior to the stock you just sold. (See the chart "Future Gains Required to Offset Capital Gains Taxes Paid," below.)  4. The tax break on long-term gains is huge For upper-income investors, the 15% tax rate applied to long-term gains is far lower than the ordinary income tax rate applied to short-term gains. For long-term gains, the chart above shows that a new stock must outperform the stock sold by a much smaller margin for you to break even. A stock with a sizeable short-term gain would have to have a dramatic negative reversal in its future prospects for an investor not to be better off deferring sale until after the one-year holding period is reached. 5. Don't be afraid to sell a stock with a large long-term gain Fortunate investors with low-cost basis holdings often become paralyzed by tax avoidance. But holding big winners can lead to a risky, undiversified portfolio. Is avoiding a 15% tax worth the risk of going down with a sinking ship like Enron? The chart above shows that even for large long-term gains, the after-tax breakeven point is not that far away. Another tax-wise strategy is to use low-basis stock for charitable giving, as one can deduct the stock's current market value and the capital gain tax liability disappears. 6. "Harvesting" losses to offset gains is a wise tax reduction strategy If you have realized gains as year-end approaches, consider selling losers in your portfolio to create realized losses that offset your tax liability on those realized gains (particularly if any gains are short-term). A more sophisticated strategy is to realize losses whenever a holding with a meaningful loss (e.g., 10% or more) can be replaced by a new stock with better prospects, creating a storehouse of losses to offset future realized gains. Next Steps Go to Schwab.com. Click on "Planning & Retirement," then "Tax." Important Disclosures This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue any investment strategy. Each investor needs to review a security transaction or investment strategy for his or her own particular situation. (0507-5952) Return to Top |
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