Five things you should consider, when capital gains can be huge, some solutions investors can consider.
1. Break-even returns for replacing stocks
The break-even returns are worth considering if you pay taxes on the fence to sell the investment.
Imagine you own stock you bought for $10,000 and is now worth $20,000. There is a deferred capital gain of $10,000. If we assume you are at a marginal tax rate of 35%, the tax payable on the stock is $1,750.
In this example, the tax would be 8.75% of the sale price. That is, $1,750 divided by $20,000 will disappear. This means you will pay 91.25 cents in dollars after tax, or $18,250 of $20,000 in sales proceeds.
If you don’t sell the stock and grow at 6% per year for the next 10 years, the pre-tax and $31,299 pre-tax is worth about $35,817. For simplicity, this is the same marginal tax rate for the entire capital gain.
If you sell today, pay the cumulative tax today and reinvest it into another stock, your yield must be 6.44% to get the same after-tax gains over 10 years. In other words, you need to increase your stake by about 0.44% on the return on your alternative investment to be in the same position.
Do you think my 6% return assumption is too low? If we use 8%, then the alternative investment will need to earn 8.54%, i.e. 0.54%, so it is not much different.
Do you think my marginal tax rate of 35% is lower based on your own situation? Higher tax rates will push up the required returns slightly to force you to sell. However, the purpose of this example is to be cautious about the fact that you cannot sell stocks because the capital gains tax is too high and you will be worse in the future. Breaking even benefits may be lower than you think.
