It’s often one of the most common mistakes investors make. By that I mean, letting the amount of capital gains tax owed on the sale of your asset, whether that’s a stock, bond, real estate or business, dominate your decision process.
It’s never easy to pay taxes, especially a 20% capital gains tax. So instead of diversifying your overall investment portfolio and not concentrating too much of your net-worth in say one stock for example, you let it ride.
Soon, five, ten, twenty+ years goes by and now this asset that has strongly increased in value and makes up close to 50% of your total investment portfolio. You know having too many eggs in one basket is risky, you know and have seen and read enough about the importance of diversification and maintaining a well balanced portfolio, yet still, even with that self-awareness, you’re allowing the tax tail to wag the dog.
Why? Why would someone that’s smart, someone that’s logical and someone that does not feel comfortable taking on too much risk with their investments allow themselves to be in such a vulnerable position?
The answer is, most investors just can’t bear the thought of paying the tax man if they sell.
Imagine you bought a stock 10 years ago and it soared in value and you now have close to a $100,000 gain. The thought of selling, capturing your gain and having to pay $20,000 capital gains tax is something you just are not prepared to do. Not to mention, that if you live in California, you could be paying up to 13.3% tax on the gain as well. Add in the 3.8% Federal net investment tax if you’re a high earner and suddenly the total tax on your $100,000 gain could be as high as $37,000, or 37%.
Capital Gain Taxes are paid on Profit
Back when I was in college, attending my federal tax course, with my favorite instructor, Professor Dixon, she would hammer it into our heads, over and over again, that paying cap gains taxes on profits was a good thing.
What she most likely knew was that all of us students were probably programmed early on to believe that paying taxes is something you dread, just like dying; death and taxes-sad! I can still remember my Dad complaining like crazy every April about the taxes he owed.
What Professor Dixon was doing was counter-programming us to understand and believe that paying taxes is not always something to dread and not always a bad thing. As she would say, successful business owners, like successful investors, have the intention to make profits, not losses. If you make profits, that’s a good thing. And along with making profits come taxes. One way to avoid having to pay taxes on your profits is to create losses.
Would you rather have losses and no taxes to pay or have profits and capital gains and have taxes to pay? Of course the answer is you would rather have profits and gains.
Bottom line: Revisit your relationship with money and think about your earliest memories of your parents during tax time. What did you observe? How has that impacted your decision making process today? How similar are the actions that you’re taking or not taking the same or different from your parents actions?
Finally, remember Professor Dixons words. Would you rather be complaining about having to pay capital gains tax on your profit and accept that has a win or would you rather have had losses and zero taxes to pay?
Be Smart: If you’ve been holding onto an investment for far too long because you just couldn’t deal with the taxes owed, whether it’s a stock or bond investment, a rental property or 1031 exchange or a business, and that investment is creating way too much risk overall, I suggest you declare it a win, take your victory lap and pay the tax man. And yes, you can still complain about the amount of taxes you have to pay, but you’ll know deep in your heart and soul you did the smart thing, and that’s what really matters.