Taxes are one of the biggest costs to investing. Ignoring income taxes when making investment decisions can be a big mistake. Being tax-smart is one of the surest ways to enhance long-term performance.
Here’s a common mistake that investors make: they periodically buy and sell stocks based on opinions of the stock’s prospects rather than on the tax implications of the decision. If a recently-purchased stock goes up, a common impulse is to sell the stock right away. Selling a stock at a profit feels good, and many investors simply cannot resist the desire to feel good now. But selling a stock at a profit shortly after it is purchased causes a short-term capital gain and therefore increases one’s income tax bill markedly.
Investors who take quick profits are usually very reluctant to sell off losers because recognizing a loss feels bad. In the long run their portfolios end up with nothing but losers – since all the winners are sold off. The investor pays tons of taxes on a string of short-term capital gains but ends with a portfolio with nothing but large long-term capital losses. These losses are worth less than short-term capital losses. I have witnessed investors hold such stocks all the way to their death – missing out on one of the few joys of dying: dying with a portfolio of stocks which huge capital gains that will never be taxed! The reason the gains will never be taxed is that most appreciated stocks can be passed to heirs with “stepped-up bases” – meaning that the heir can liquidate the stock without incurring any Federal income tax liability.
There are other important tax-blind mistakes that investors make – such as putting highly taxable securities such as bonds in taxable account and putting tax-preferred investments such as low-dividend stocks in their retirement accounts. Taxes are a huge potential expense. Most investors would do very well to put most of their focus on tax minimization and far less of their focus on trying to “beat-the-market” through active trading.