“Never let the tax tail wag the investment dog” is a widely used Wall Street saying. Many clients, after watching their non-qualified stock portfolios steadily rise for four straight years (the S&P 500 is up about 115% since mid-October 2022, which is roughly a 21% average annual return) are sitting on some large capital gains. Numerous stocks experienced significant gains over the last year. Our tax-centric focus ensures we try to minimize our clients’ tax burden, but we often observe that some clients have an aversion to recognizing gains and paying the resulting capital gains taxes.
It’s natural to want to avoid paying taxes, but the main goal is after-tax wealth, not just a smaller tax bill. Consider a hypothetical scenario with three different investors, all of whom were fortunate enough to own a stock (“XYZ”) that returned 100% over the last year (and assume each investor started with a $100,000 position in XYZ):
- Investor 1 sells half the XYZ position, pays the capital gains tax (assume 20%), and reinvests the proceeds in bonds with a 5% annual yield.
- Investor 2 sells the entire XYZ position, pays the capital gains tax (assume 20%), and reinvests the proceeds in bonds with a 5% annual yield.
- Investor 3 sells nothing and thus pays no capital gains tax.
Over the next two years, stock XYZ drops 50%, and bonds return 10%. At the end of year three:
- Investor 1 has $138,000, representing a 38% cumulative return over three years
- Investor 2 (who paid the most capital gains taxes) has $176,000, representing a 76% cumulative return over three years
- Investor 3 has $100,000, representing a 0% cumulative return over three years
Obviously in hindsight Investor 3 looks unwise, but such scenarios are quite possible given some behavioral phenomena like loss/regret aversion and overconfidence.
It’s impossible to know when this AI-fueled bull market party will end, but it will end at some point, and the real question is how bad the hangover will be. We encourage clients to recognize that a bird in the hand beats two in the bush, even after the IRS takes a feather.
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This material is for informational and educational purposes only and is not intended as individualized investment, tax, or legal advice. The hypothetical example presented is for illustrative purposes only, does not represent any actual client experience or investment, and is not a guarantee or indication of future results. The example assumes a 20% federal long-term capital gains tax rate and a hypothetical 5% annual bond return compounded annually. Different assumptions regarding investment performance, tax rates, reinvestment returns, and other factors would produce materially different results. It does not account for state or local taxes, the Net Investment Income Tax, transaction costs, fees, expenses, or other factors that could materially affect actual results. Tax treatment depends on individual circumstances; investors should consult their tax professional regarding their specific situation. Bonds are subject to risks, including interest-rate, credit, and market risk. References to market or index performance are historical, and past performance does not guarantee future results. The S&P 500 Index is unmanaged, and investors cannot invest directly in an index. Any views regarding future market conditions are opinions as of the date of this material, are subject to change, and should not be considered a prediction or guarantee of future results.