It has come to my attention that I never discussed when to sell equities. It’s a valid point, and my defense is that, in my mind, the optimal holding period is forever. While that may not be possible for most, where possible, that’s the path to the most efficient wealth accumulation. My reasons are two-fold: I am not omniscient, but I do have to pay taxes.*
Whereas the market looked compelling in March, valuations appear a little rich here. I have no idea if the market is correctly forecasting a return to strong economic growth we enjoyed pre-virus or Jeremy Grantham is right when he says this is the fourth great bubble of our time built by Federal Reserve easy money. I simultaneously acknowledge that:
1) Grantham and his ilk know a lot more about the market than I do;
2) he and other professionals have a vested, financial interest in talking their book, which may well be short U.S. equities; and
If the greatest investor of all time and Britain’s Chancellor of the Exchequer (prior to becoming Prime Minister) cannot accurately decipher moves in various markets, no one can. Accordingly, I prefer to deal in certainties.
My expertise is in tax, estate planning and retirement issues, and I can definitively say that selling equities – unless it’s a tax advantaged account or to offset capital losses – is financially disastrous for long term wealth accumulation. Depending on your income and filing status, you will “enjoy” a 0% (unlikely), 15% or 20% haircut under our current tax structure for long term capital gains for equities owned longer than 1 year (incidentally, Joe Biden’s plan calls for significant increases, including nearly a 40% capital gains rate for the highest bracket). If you own the stock(s) for a year or less, you are taxed at your ordinary income rate, which is almost assuredly higher.
“The first rule of compounding: Never interrupt it unnecessarily.”
Death and taxes may be the only two certainties in life, but you can defer some of the latter until you cannot avoid the former… or maybe not pay any at all. There are several tricks of the trade around paying lower taxes. Grantor trusts, irrevocable trusts, Donor Advised Funds, IRAs and 529 plans are some of the ones I plan to detail on this site, but it’s worth first discussing the tax efficient theory of stepped up basis at death.
If you never sell your equities – and instead are able to live on the dividends, social security and perhaps a pension if you’re lucky – then you may avoid paying tax altogether. Currently, your estate would have to exceed $11,580,000 (or double that amount if you’re married) to pay additional taxes. That number will vacillate according to the political whims of Washington. The current threshold may well be headed lower after the coming election, so accelerating gift transfers may be beneficial for very wealthy individuals. Also, many states impose additional taxes at death on the estate or the inheritor.
Stepping up the taxable basis of your equities at death is arguably the most efficient way to compound wealth while providing for your family. For example, let’s say you owned $500,000 in an S&P 500 index fund and $500,000 in bonds located in taxable accounts. Also, the value of your home and land was $500,000. At death, your assets would be well under the $11.58 million-dollar threshold.
Accordingly, your heirs will avoid paying federal tax on that amount of money. Additionally, if/when they decide to sell those assets, they will only be taxed on the amount those assets have appreciated since your death (for equities, you can also use the value of these assets 6 months after death if that is more beneficial by filing IRS Form 706). For example, if the S&P 500 index funds owned by your heirs is worth $750,000 ten years later when they sell, they will only owe taxes on the $250,000 the equities have appreciated.
So, how do you know when to sell if you have to? Ideally, if you believe you will need the money in the next five to ten years, it’s prudent to set that amount of money aside. I worry less about what will happen in the market (because it’s unknowable as discussed above) and more about the “what ifs” life has in store for you. What if I need to pay for my kid’s college and the market corrects when I need the money? What if I retire and the market crashes just before or immediately thereafter? What if I need the money, but we have a giant pandemic that shuts the economy down triggering the fastest market crash in history, massive unemployment and widespread social unrest? That last one seems a bit specific.
*With Independence Day upon us, I find there are few things more patriotic than paying one’s fair share of taxes. After all, we enjoy the public services provided by our tax dollars. Indeed, for the past fourteen years, my salary has been paid by taxpayer contributions to protect the American Dream; however, there is a big difference between paying one’s fair share and foolishly paying extra because we don’t understand various aspects of the tax code. After all, this country was built on capitalism, not foolishness.