Weighing nontax issues
Although the focus of this chapter is on tax issues to consider when making, managing, and selling your investments, it’s time to raise bigger-picture considerations:
Meeting your goals and preferences: If your life has changed (or if you’ve inherited investments) since the last time you took a good look at your investment portfolio, you may discover that your current holdings no longer make sense for you. To avoid wasting time and money on investments that aren’t good for you, be sure to review your investments at least annually. Don’t make quick decisions about selling. Instead, take your time, and be sure you understand tax and other ramifications before you sell.
Keeping the right portfolio mix: A good reason to sell an investment is to allow yourself to better diversify your portfolio. Suppose that through your job, you’ve accumulated such a sizeable chunk of stock in your employer that this stock now overwhelms the rest of your investments. Or perhaps you’ve simply kept your extra money in a bank account or inherited stock from a dear relative. Conservative investors often keep too much of their money in bank accounts, Treasury bills, and the like. If your situation is like these, it’s time for you to diversify. Sell some of the holdings of which you have too much, and invest the proceeds in some of the solid investments that I recommend in this book. If you think your employer’s stock is going to be a superior investment, holding a big chunk is your gamble. At minimum, review Book 3 to see how to evaluate a particular stock. Be sure to consider the consequences if you’re wrong about your employer’s stock. Develop an overall investment strategy that fits your personal financial situation (see Chapter 3 in Book 2). A problem with holding a large amount of stock in your employer is that both the stock and your job are compromised if the company has a significant downturn.
Deciding which investments are keepers: Often, people are tempted to sell an investment for the wrong reasons. One natural tendency is to want to sell investments that have declined in value. Some people fear a further fall, and they don’t want to be affiliated with a loser, especially when money is involved. Instead, step back, take some deep breaths, and examine the merits of the investment you’re considering selling. If an investment is otherwise still sound per the guidelines discussed in this book, why bail out when prices are down and a sale is going on? What are you going to do with the money? If anything, you should be contemplating buying more of such an investment. Also, don’t make a decision to sell based on your current emotional response, especially to recent news events. If bad news has hit recently, it’s already old news. Don’t base your investment holdings on such transitory events. Use the criteria in this book for finding good investments to evaluate the worthiness of your current holdings. If an investment is fundamentally sound, don’t sell it.
Tuning in to tax considerations
When you sell investments that you hold outside a tax-sheltered retirement account, such as in an IRA or a 401(k), taxes should be one factor in your decision. If the investments are inside retirement accounts, taxes aren’t an issue because the accounts are sheltered from taxation until you withdraw funds from them.
Just because you pay tax on a profit from selling a nonretirement-account investment doesn’t mean you should avoid selling. With real estate that you buy directly, as opposed to publicly held securities like real estate investment trusts (REITs), you can often avoid paying taxes on the profit you make. (See Book 8 for an introduction to real estate investing.)
With stocks and mutual funds, you can specify which shares you want to sell. This option makes selling decisions more complicated, but you may want to consider specifying what shares you’re selling because you may be able to save taxes. (Read the next section for more information on this option.) If you sell all your shares of a particular security that you own, you don’t need to concern yourself with specifying which shares you’re selling.
Determining the cost basis of your shares
When you sell a portion of the shares of a security (such as a stock, bond, or mutual fund) that you own, specifying which shares you’re selling may benefit you taxwise. Here’s an example to show you why you may want to specify selling certain shares — especially those shares that cost you more to buy — so you can save on your taxes.
Suppose you own 300 shares of a stock, and you want to sell 100 shares. You bought 100 of these shares a long, long time ago at $10 per share, 100 shares two years ago at $16 per share, and the last 100 shares one year ago at $14 per share. Today, the stock is at $20 per share. Although you didn’t get rich, you’re grateful that you haven’t lost your shirt the way some of your stock-picking pals have.
The Internal Revenue Service allows you to choose which shares you want to sell. Electing to sell the 100 shares that you purchased at the highest price — those you bought for $16 per share two years ago — saves you in taxes now. To comply with the tax laws, you must identify the shares that you want the broker to sell by the original date of purchase and/or the cost when you sell the shares. The brokerage firm through which you sell the stock should include this information on the confirmation that you receive for the sale.
The other method of accounting for which shares are sold is the method that the IRS forces you to use if you don’t specify before the sale which shares you want to sell — the first-in-first-out (FIFO) method. FIFO means that the first shares that you sell are simply the first shares that you bought. Not surprisingly, because most stocks appreciate over time, the FIFO method usually leads to your paying more tax sooner. The FIFO accounting procedure leads to the conclusion that the 100 shares you sell are the 100 that you bought long, long ago at $10 per share. Thus, you owe a larger amount of taxes than if you’d sold the higher-cost shares under the specification method.
When you sell shares in a mutual fund, the IRS has yet another accounting method, known as the average cost method, for figuring your taxable profit or loss. This method comes in handy if you bought shares in chunks over time or reinvested the fund payouts in purchasing more shares of the fund. As the name suggests, the average cost method allows you to take an average cost for all the mutual fund shares you bought over time.
Selling large-profit investments
No one likes to pay taxes, of course, but if an investment you own has appreciated in value, someday you’ll have to pay taxes on it when you sell. (There is an exception: You hold the investment until your death and will it to your heirs. The IRS wipes out the capital gains tax on appreciated assets at your death.)
Capital gains tax applies when you sell an investment at a higher price than you paid for it. As explained earlier in this chapter, your capital gains tax rate is different from the tax rate that you pay on ordinary income (such as from employment earnings or interest on bank savings accounts).
Odds are that the longer you’ve held securities such as stocks, the greater the capital gains you’ll have, because stocks tend to appreciate over time. If all your assets have appreciated significantly, you may resist selling to avoid taxes. If you need money for a major purchase, however, sell what you need and pay the tax. Even if you have to pay state as well as federal taxes totaling some 35 percent of the profit,