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What's Worse Than Paying Taxes? Not Having to Pay Taxes

Minimizing taxes is important, but you can get carried away. The following example will illustrate the point.

In August 2004, Mike buys 200 shares of Google at $100 per share. The $20,000 investment represents 5 percent of his $400,000 portfolio, which has half in Treasury bonds. By December 2007, Google skyrockets to 700, making his shares worth $140,000 and representing almost 25 percent of his now $600,000 portfolio. Also, his equity allocation had grown from 50 percent to almost 70 percent.

Mike realized his portfolio had become considerably more risky by having nearly one quarter of his portfolio in a single stock and by having a higher allocation to equities. However, selling would result in a large capital gains tax. Assuming a total Federal and state tax rate of 20 percent, the tax on his $120,000 gain would be $24,000. He refused to sell, letting the minimization of taxes drive his decision instead of the management of risk.

By January 2009, the stock had fallen below 300, and his investment was now worth less than $60,000. If he had sold the stock at 700, the sale would have produced net cash of $116,000. Realizing how much the lost opportunity had cost him, Mike redoes the math and finds the tax bill will be just $8,000 if he sells at 300. He will still have a nice profit as he will realize a net of $52,000 (not bad for his $20,000), so he sells. Trying to avoid the $24,000 capital gains tax bill cost our investor $62,000.

Investors who have a very low basis in a stock often let the tax situation drive their decisions, forgetting the large risks they're taking.

Obviously, with hindsight, the investor in our example would have been better off selling the stock and paying the tax. However, no hindsight is needed to prevent this type of mistake from occurring. Two things are required:

  • The first is a written investment policy statement (IPS) with a rebalancing table.
  • The second is the discipline to adhere to the plan.
An IPS should limit the allocation of any one stock or asset class within the portfolio. For example, Mike might have established a maximum buy limit for any one stock of 5 percent of the total portfolio. The maximum hold range might be set at 10 percent. If a stock exceeds 10 percent, he would sell enough shares to return the stock's position within the portfolio to the maximum 10 percent level, or even to the target 5 percent (depending on his rules).

There's one other way you can avoid the mistake of being trapped by taxes: Remember the only thing worse than having to pay taxes is to not have to pay them.

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