Let’s talk about taxes.
This is something I see and hear ALL the time. “I don’t want to sell now because then I’ll have to pay short-term capital gains tax.”
So people will hold onto a stock, ETF or other investment until that “magical” one year mark has been reached — even if it means taking a significant loss in the value of their investment.
I recently spoke with a friend who had lost close to $150,000 ($285 — PER SHARE!! on a $400 stock!!) on a stock because this was a “long term” investment and he didn’t want to have to pay short-term capital gains on profits if he sold it sooner.
I have heard variations on this story so many times and it quite literally blows me away. People would rather lose 30%, 50%, even 75% of their investment than sell before that 1 year mark.
Where does this thinking come from???
Let’s take a look at the numbers and try to make sense of this behavior.
For 2019-2020, the US tax brackets were as follows (ref):
Looking at US census bureau data from 2017 (the latest available), the average (median) household income was right around $61k (ref). This includes all households regardless of size — encompassing individuals as well as married households, putting the “average” tax bracket at either 22% (for married couples) or 24% (for individuals).
Tax bracket explanation
As a side note, this does not mean that all $61k is taxed at the same tax rate. Taking a look at an individual, the first $9,700 is taxed at a 10% rate, the next $29,775 (the difference between 39,475 and 9,700) is taxed at 12%, and the final $21,525 ($61k – 39,475) is taxed at 22%. This visual might help:
If you are filing as a married couple, here is the breakdown for your tax bracket:
Short-term vs Long-term
So let’s take a look at taxes on your investments.
Short-term capital gains are investments that are held for less than one year and are taxed at your current tax bracket. So our individual who makes $61k would be taxed at 22% for any capital gains that he or she held for less than one year.
Long-term capital gains are defined as investments that are held for more than 1 year. Taxes on these are also based upon your filing status as well as your income level.
So if we go back to our example of an individual making $61k, then any long term capital gains are taxed at 15%.
Yes, short-term gain taxes are higher than long-term gain taxes (22% is higher than 15%) — by 7%. The numbers are fairly clear. But what is not clear is the analysis of how much you stand to lose if you hold on to an investment during a down-turn, just to avoid a 7% increase in taxes.
Holding onto an investment for 1 year can cost you substantially more
Let’s stick with our example of you being a $61k earning individual and be crazy and say that you stand to make $3,000 on a stock that you have held for 6 months (way to go — you picked a good one!!). If you sell it now, you’ll pay 7% more in taxes than if you held it for an additional 6 months. That additional 7% tax equates to $210.
Now, if this great stock that you picked continues to go up, then by all means, there is no reason to sell it. You can hold onto it, get an even better return and keep your $210.
However, if this stock changes direction and is no longer increasing in value and you start to lose your profits, how long do you want to hold on just to avoid paying that $210? It doesn’t take too much of a change for you to lose $210 from your $3000 profit — just for the sake of not paying Uncle Sam an “extra” $210. Do you see any logic in this thinking??
Of course different financial situations result in different numbers. Take a look at the charts above to see where you fit. Maybe you stand to pay more than a 7% difference in taxes if you hold on for that “magical” one year mark. But regardless of your specifics, YOU NEED TO KNOW and understand what your tax ramifications are and how they affect your bottom line. Holding onto an investment and watching it lose 40% or more of your profit just to avoid a 7% increase in taxes is, umm, well, might I say, ludacris.
All of this is moot if your investments are in a retirement account. Within your 401k, traditional IRA or other similar retirement vehicles, you can buy and sell without regard to timeframes and will only pay taxes when you withdraw funds in your retirement. If you have a ROTH IRA then you will not pay any taxes on your gains regardless of how long you hold them.
Just for clarification, I am not a certified tax specialist, and my opinion should not be taken as advice. On second thought, my only real opinion is to make sure that you understand the tax ramifications for yourself and take the time to look at your specific numbers before blindly holding on to an investment for that “magical” one year time point. It might cost you a heck of a lot more to hold on to that stock than the extra dollars that you would have to pay to Uncle Sam if you sold it sooner.