Once again, many people are moving and selling without correct information. At this point, no one knows what tax rates will be in 2013. Many think they will be higher, but unless your "taxable income" is more than $250,000, and not your gross income, you could be making a big mistake by selling in 2012 to avoid the tax bite.
Let me take the easy one first — investors who sell their dividend-paying stocks because taxes could increase by 13 percent on those dividends. If one has a stock yielding about 1.9 percent, with the additional 13 percent potential tax on dividends, the after-tax yield would be approximately 1.65 percent. The consensus projection is for dividends to rise by about 11 percent next year, virtually wiping out the potential tax increase.
Based on current payout ratios from companies, dividends will probably increase again in 2014, putting investors in a better place than before. And that doesn’t include any price appreciation on the stock.
The next important issue: Once you've sold the stock for tax reasons, where do you put the money that will give you a better yield? Please don’t say bonds. Bond interest is fully taxable unless you invest in municipal bonds. But remember, when interest rates go up, bond values go down, whether it is a taxable or tax-free bond.
The second decision that investors are making on the assumption of higher tax rates is to sell now and pay a lower capital-gains rate this year. This is one reason why some investors don’t do well investing in stocks — they sell for the wrong reason. One should never sell a stock to save on taxes. One should sell a stock, or any investment for that matter, based on the value of that investment. If it is overvalued or at full value, sell it. If not, hold on to that investment.
Let me give you an example: A smart investor bought 100 shares of stock for $80 per share two years ago, and today the stock is $100 per share. If a smart investor pays a current capital-gains rate of 15 percent, he will pay $300 in taxes ($2,000 gain times 15 percent = $300). If he waits until next year, the capital gains rate could be 20 percent, so his taxes will increase to $400 ($2,000 gain times 20 percent = $400).
Now hopefully he is smart enough to buy back that company, but many won’t buy back that stock for whatever reason, which will leave potential gains on the table.
But if he is smart enough to buy it back, here is what could happen. In reality he will only be able to invest $9,700 because $300 went to Uncle Sam. Let’s assume that he gets the same $10 price at which he sold, which is not likely, but I’m trying to be nice. He now has 97 shares. Let's assume that the stock becomes fully valued at, we'll say, $120 per share 11 months later. That stock should be sold because it is fully valued.
When it is sold, that investor will pay short-term capital at a 28 percent bracket or higher on the $1,940 gain, or $543 ($1,940 times 28 percent = $543). The combined tax on this stock is $843 (the long-term gain in 2012 of $300 plus the short-term gain of $543 = $843). Net investment return would be $3,157, or 31.57 percent. Had the smart investor waited until the company became fully valued and sold just once on November 2013 at $120 per share, his taxes would have been $800 and his net gain would have been 32 percent.
People try to get too fancy when it comes to stocks and then blame the stock market, or say stocks are too risky, when they lose money.
Stocks are nothing more than small pieces of a large business and should be treated as such.
Instead of looking for reasons to always sell their stocks, investors should be looking at the stock as a business and tell themselves, "If it’s not overvalued and paying a good dividend, then I will not sell." Let the company grow and compound for you, and if it becomes overvalued, then sell.
Warren Buffett has made billions by compounding over years, and not once did he ever make a sell decision based on taxes. You, as an investor, should do the same. Base your investment decisions on the economics of the investment, not taxes or anything else.
Have a question or a company you'd like me to take a look at? Email me at email@example.com.