Taxes shouldn't be No. 1 in considering a stock sale
As the great bull market of 1982-8? approaches the end of its first year, many fortunate investors are finding themselves with large windfall profits. With the popular market averages up 60 percent since last August, it's not surprising to find gains of 100 or 200 percent, even much more. Not in American Telephone, Exxon, or Eastman Kodak, but certainly in IBM, Digital Equipment, or numerous software, health-care, and a host of upstart high-technology issues.
For some investors it will soon be time to cash in - to realize long-term capital gains - the kind that are far less subject to taxation. Individual needs and circumstances change, portfolios become overweighted with stocks, better opportunities exist elsewhere. And don't forget that some stocks will become grossly overpriced.
But will investors sell? Some of them will, but many will fall for the old line, ''I'm locked in - my cost is so low I'd be killed by the tax.''
This argument is hogwash. For some people it is a not so subtle way of boasting, to talk about their Hewlett-Packard which cost $1.50 a share, or Wang Laboratories at 75 cents. If they sold them, what else could they talk about among their treasures?
Consider the size of the tax. If property has been held one year before sale, 60 percent of the gain is exempt from federal tax, and the balance is taxed at your maximum rate. If you're in the top bracket of 50 percent, this means you'll pay a tax of 20 percent on long-term gains. If your bracket is 40 percent, then 16 percent is your long-term gains rate, or for a 30 percent bracket it's 12 percent.
Some of the states tax capital gains, too, but these taxes, usually modest, are deductible expenses on Form 1040. Adding federal and state together, the tax is still far cheaper than what you'd pay on a fat bonus or an extra dividend, both taxable as ordinary income at your top rate.
Capital-gains taxes are now considerably less than they were a few years ago, and there's no assurance another administration in Washington won't decide this is a loophole to close.
Of course it's important to consider the impact of taxes in an investment decision, but taxes don't rate high on my list of criteria for judging whether an investment should be sold. That decision should be based on the outlook for the company, the price/earnings ratio, the recent price history of the stock, and a host of other factors.
Often overlooked are the alternative investment opportunities for the money. Successful investing is like moving from one elevator to another. You hope the next one you choose will go up higher than the one you were on. Ideally, elevator No. 1 (your original one) goes down when you get off, and No. 2 goes up.
Even if No. 1 continues to go up, you'll be better off on No. 2 if it outpaces No. 1. But what about the tax you had to pay? That's the equivalent of moving you back a few floors. If No. 2 does better than No. 1, you'll soon be better off.
That reasoning demolishes the argument that if you sell a stock at a profit, it would have to decline by the amount of the tax before you'd be even and could buy it back. Of greater importance is what you do with the proceeds from the sale.
For many people taxes are a highly emotional issue. They hate to pay them in any form, and since the realization of capital gains is discretionary, that tax is one that can be avoided. But at what cost? Think of the 1960s when American Telephone & Telegraph sold at 75 (now 61), General Motors at 112 (now 75), and US Steel at 67 (now 25). How absurd for people to refuse to sell because they thought the tax penalties were too great.
One can also look to the '70s for more recent examples - Eastman Kodak at 152 (now about 72), Polaroid 149 (now 28), or Xerox 171 (now 46).
The decision to sell a stock should be independent of the tax consequences. One ought to consider not only the merits of the stock, but whether an alternative investment might be expected to pay off in a bigger way, even though in an extreme case only 80 cents of each dollar realized from the sale could be reinvested.
In coming weeks, as the one-year holding period is reached, large numbers of investors will be wondering what to do with stocks that have treated them so well. The wisest among them will pay scant attention to the capital-gains tax. For the moment, it's one of the cheapest taxes they pay.
The stocks have it. With returns of nearly 10 percent (non-annualized), common stocks outperformed fixed-income issues for the third consecutive quarter , according to a recent Salomon Brothers Inc. bond market report.
Intermediate- and long-term sectors for the fixed-income market averaged barely positive returns in the second quarter. It was the poorest showing in nearly two years, and these sectors underperformed the short-term market for the first time in a year.
Highlighting the top common stock performers, transportation stocks led the way with a 14 percent return. Industrials trotted in second with results of 9 to 11 percent, as both stock groups kept abreast of first-quarter returns.
Banking and finance stocks, however, did not fare so well this quarter. They slipped from 15 percent to returns of 6 to 7 percent. Utilities finished last among the major common stock groups for the fourth straight quarter. But with a 5.7 percent average return, they did finish up from the first quarter. Convertible bond performance slid from 16 to 5.7 percent.
The market surged ahead in a broad rally early last week, hitting the 1,243 mark, but then went into a three-day tailspin, finishing up at 1,199.22, down 31 .95 points for the week.
The downdraft was led by a high-technology sell-off Wednesday when it was reported that IBM's Peanut personal computer might be introduced Sept. 1. The fall continued the following day when Federal Reserve chairman Paul Volcker said government and private-sector borrowing needs were beginning to clash. The Friday money supply and interest rate jitters kept the market headed south despite a rise in leading economic indicators and non-farm productivity.