Here are five things you should think about when a capital gain could be significant, and some solutions investors can consider.
1. The break-even return for a replacement stock
The break-even return is worth considering if you are on the fence about paying tax to sell an investment.
Imagine you own a stock that you purchased for $10,000 and is now worth $20,000. There is a $10,000 deferred capital gain. If we assume you are in a 35% marginal tax bracket, the tax payable on the sale of the stock would be $1,750.
That tax would be 8.75% of the sale price in this example. That is, $1,750 divided by $20,000 would disappear to tax. That means you would keep 91.25 cents on the dollar after tax, or $18,250 of the $20,000 sale proceeds.
If you did not sell the stock and it grew at 6% per year for the next 10 years, it would be worth about $35,817 pre-tax and $31,299 after-tax. For simplicity, this assumes the same 35% marginal tax rate for the entire capital gain.
If you sold today, paid the accumulated tax today, and then reinvested into another stock, your rate of return would need to be about 6.44% to have the same after-tax proceeds in 10 years. In other words, you would need to earn about a 0.44% higher rate of return on a replacement investment to be in the same position.
Do you think my 6% return assumption is too low? If we use 8% instead, the replacement investment would need to earn 8.54%, or 0.54% more, so not much different.
Do you think my 35% marginal tax rate is low based on your own situation? A higher tax rate would push up the required return slightly to compel you to sell. But the point of this example is to be careful about thinking you cannot possibly sell a stock because the capital gains tax is too high, and you will be worse off in the future for doing so. The break-even return may be lower than you think.
