This week we wanted to discuss a question that almost every investor has faced, or will face, in their lifetime – “I have a lot of capital gains in investment XYZ, should I sell?”
We’re not talking about whether investment XYZ is a good investment, or if now is the “right time” to sell, we’re focusing specifically on how taxes impact the analysis of this question.
If no capital gains taxes were involved, as is the case with retirement accounts, the answer would be simple – You should sell investment XYZ any time you can swap it with a better investment. However, with taxes, the answer is a bit more complicated. In this case, the question becomes – how much better does the new investment need to be to justify selling investment XYZ and paying the taxes?
Often, we find that after an investor has experienced large gains in their investment, they are very hesitant to sell. It is easy to see why. Selling will result in taxes owed, sometimes to the tune of thousands, or even hundreds of thousands, of dollars. Parting with this money to pay the IRS can be a big deterrent against selling. But is this the right choice? We’ll show that while taxes are important, your choice in investments is what should drive this decision instead.
We’re going to get into some data and discussion that may bore some of you. If you just want the takeaway, skip to the conclusion at the bottom.
As with most things tax, the answer can get complicated quickly, so we will make some simplifying assumptions:
- You plan to sell investment XYZ at some point before you or your spouse passes away. This removes any complications related to a step-up in cost basis.
- You have, or will hold, all assets for at least a year and the applicable tax rate is the 20% capital gains rate. This is the highest capital gains tax bracket.
- All assets are sold at the end of the holding period. This ensures there are no lingering capital gains taxes that are still owed.
- There are no dividends, as the impact is usually minimal.
- There are no interest payments. These are usually associated with fixed income investments that are less likely to experience large increases in capital gains.
Even with the above assumptions, it’s important to realize that there are still infinite possible scenarios we could analyze here. The point of this Weekly Thoughts is not to answer all of them, but instead to guide decisions on this matter.
Also, while we discuss this in terms of “investment XYZ,” the same math can be applied to an entire portfolio with similar gains instead.
Let’s start with an example. Assume investment XYZ has appreciated 50% since you purchased it (importantly, it does not matter if investment XYZ is now worth $100 or $1,000,000, the math will be the same). Furthermore, let’s say you expect investment XYZ to earn 6%, per year, going forward. What return would a new investment need to have to overcome the tax impact? The below chart answers this question for different holding periods.
Put another way, if investment XYZ has already appreciated 50%, and you expect it to earn 6% over the next 5 years, you will need the new investment to earn 6.38% per year, or more, to overcome the taxes. This comparison assumes that you will sell investment XYZ in year 5 versus purchasing the new investment and selling that in year 5.
As you can see, the longer you plan to hold the investments, the smaller the new investments return needs to be.
How does this change if you expect the return on investment XYZ to be lower than 6%? What about higher? The charts below show what the new investment will need to return if you expect investment XYZ to earn 4% and 8%, respectively.
We’ve been assuming that investment XYZ has appreciated 50% since its purchase, but what if it has doubled (up 100%), or even quadrupled (up 300%)? What if it’s only up 30%? As you might expect, the higher the capital gains, the higher the new investment’s return needs to be.
So, what’s the takeaway from all this? Generally speaking, if you are looking to sell your existing asset, you will need the new investment to do somewhere between 0.30% and 0.70% better, per year. The average from the above examples is around 0.50% although smaller capital gains, lower future expected returns for investment XYZ, and longer holding periods will decrease this number, and vice versa. We did not show these figures, but if you are in the 15% capital gains tax bracket, instead of the 20% bracket assumed here, these numbers will decrease by around 0.10% to 0.20%.
The point of this analysis is not to encourage you to dwell on the expected difference in asset returns, or to lose sleep over whether your new investment will do 6.10% or 6.30%. Rather, it is to show that the outperformance needed from the new investment is not, say, 3%, or 5% higher than your old investment. Certainly, it is not so high that you should avoid selling at all costs. In many cases, finding an investment you expect to do, at least, 0.50% better is not a huge hurdle.
This is especially true when you consider the circumstances that often surround this decision. Often, the investor feels their investment has run its course and does not expect it to do as well in the future, hence the consideration to sell. In these cases, holding on to an inferior asset simply because you don’t want to pay the taxes is rarely the correct decision.
Finally, you’ll notice that we did not talk about nominal dollar values in this analysis. For example, say you’re $5,000,000 investment is now worth $7,000,000. That $2,000,000 in capital gains will result in a tax bill worth $400,000! Surely this must change the above analysis?… But the answer is no. In fact, you’re 40% gain is on the low side compared to the examples above. It is important not to lose track of the right decision just because you are dealing with higher dollar values.
None of this is to say that taxes do not matter at all. They certainly can, especially in the cases where the assumptions outlined above are not true (specifically the ones regarding no step-up in cost basis or assets held for less than a year). However, what we hope to make clear is that in most cases, the main driver in your decision should be expected investment returns, not a concern over a large tax bill. We realize this can be easier said than done, but we hope that understanding the data behind it can help.
This article should not be considered tax advice. Please consult your accountant or tax advisor before making any decisions.