A blog about stock portfolio management

When to sell stock: consider prior capital gains

May 29, 2009

For taxable portfolios, after-tax return can be much lower than before-tax return. One reason: short-term capital gains incur the same tax rate as ordinary income. For investors subject to the top 35% marginal tax rate, a short-term gain brings on a tax that lowers its return by 35%.

To put that into numbers, the tax cost on a $10,000 short-term gain is $3,500. That lowers its after-tax gain to only $6,500.

Unequal tax on investment gains

The tax code provides chances to reduce taxes, since not all investment gains are taxed equally. Long-term capital gains get a more favorable 15% tax rate. At $1,500, the tax cost of a $10,000 long-term gain is $2,000 less than that of a similar short-term gain.

One should note that other costs, such as trading commissions or management fees, do not even begin to approach this 'favorable' 15% rate.

Recognizing losses to offset gains

For a portfolio having the gains described above, the capital gains tax would total $5,000 ($3,500 plus $1,500).

Suppose that this portfolio also had stock positions with unrealized losses of $10,000 short-term and $10,000 long-term. If the investor were also to sell those positions, the realized losses would offset all of the gains. Having no net capital gain, instead of a $5,000 tax, the tax would be zero.

In this case, selling stock at a loss has preserved some of the investor's wealth.

Figuring capital gains at the end of the year may not result in the lowest tax

Some people wait until tax season to tally their capital gains. Tax preparation software does a great job with this. So do tax preparers. Both methods should result in the same capital gains tax as reported on the Schedule D. Why?

The net capital gains are determined solely by the actual portfolio trades. Unless the losses were already taken, no realized losses would exist to offset the gains and lower the tax. Neither the expertise of an accountant, nor the 'intelligence' of any software, can change the realized net gains.

Consider the tax impact before making a trade

All closing trades change an investor's net capital gains. Throughout the year many trading opportunities arise as a result of unforeseeable market action. Not all investors know the amount of their total gains when they place an order to sell stock. Those who do know have a chance to make a trade that does not expose the portfolio to avoidable tax.

Tags: capital-gain, costs, return, and tax