2012-03-19 12:03:25
April 30 2007 | Filed Under Retirement , Stocks
The vast majority of financial literature is concerned with when to buy a stock
and how to get a deal. The assumption seems to be that the time to sell is
self-explanatory. The truth is that selling is just as important and intensive
an operation as buying. In this article, we will take a look at the main points
you should consider when selling an investment.
Reasons to Sell
In general, investors want to offset gains until they can realize them in a
lower tax bracket. When you are at your earning prime, for example, investing
income will be taxed more stringently than when you are retired. Consequently,
there are only a few reasons to sell before that time.
The most common reason is to adjust your portfolio. There are many reasons that
a portfolio might become unbalanced or inappropriate for your investing goals.
This might be a lifestyle change like marriage, divorce, retirement, the birth
of a child or merely an accidental concentration of capital in one sector.
Putting all of your stocks in one sector - or even putting all of your money
into a certain risk level of investments - is a dangerous game. Diversifying
generally negates the chance that you will lose everything at once, but you
have to be careful not to over-diversify, which will hamper your portfolio's
growth. When your portfolio needs to be diversified or, in the case of
over-diversification, refocused, the goal is to incur as few fees and taxes as
possible while making the changes. We will look at how to do that shortly. (To
learn more, see The Dangers Of Over-Diversification and The Importance Of
Diversification.)
The other reason to sell an investment is to free up capital - whether to make
a down-payment on a house, finance your new business, pay for major surgery,
take a vacation, etc. The best way to free up capital is to realize losses to
offset your gains. If you have two investments - one that has experienced gains
and another that has suffered losses - you can sell them both to avoid having
an overall profit that is prey to capital gains tax. (To learn more, see A
Long-Term Mindset Meets Dreaded Capital-Gains Tax and Capital Gains Tax Cuts
For Middle Income Investors.)
There are a few conditions that you have to satisfy to do this:
The stock or securities that you are selling have to have been in your
ownership for at least a year. (Although there is a rate schedule for both
long-term and short-term gains and losses, the long-term rates are more
favorable and less complex.)
There is a limit to the net losses you can post in a given year. If you are
over the limit, you have to carry over the losses to later years (complicating
your tax forms and postponing the value of the write-off).
You have to conform to the wash sale rules. If you buy back the investment you
sold for a loss within a 30-day period, it negates the deduction - after 31
days, you are fine. You can dodge this by buying a comparable investment if you
don't want the money sitting idle. Be careful to mind the rules when using this
strategy. (For more insight, see Selling Losing Securities For A Tax Advantage
and Using Tax Lots: A Way To Minimize Taxes.)
If you really need the money, don't let taxes keep you from selling. If your
only other option is a loan, then you are better off to eat the tax, curse the
government and spare yourself years of high interest debt payments. In terms of
raising capital, you are better off (as far as taxation is concerned) to sell
large holdings with modest gains rather than smaller holding that have had
larger gains. Make sure to calculate how much you will be paying in taxes and
fees, and check that you will have the amount you need when all is said and
done.
Reasons Not to Sell
Selling because of a bad quarter or a rough year is one of the worst reasons to
sell an investment. Assuming that due diligence has been done and the
investment is sound, bad quarters are when you should be buying more. Dips in
the price of a solid company can be caused by any number of factors unrelated
to the company's performance, such as a sector-wide correction, a bear market,
rumors or investor panic - just to name a few. If you react after a bad
quarter, you are reacting to old information - the damage has already been done
and repairs are underway. A little bit of stoicism will go a long way toward
strengthening your portfolio and your skills as an investor.
Another dubious motivation to sell is to unload or cash in on inherited
investments. Investors often feel less favorable toward these investment
because they didn't choose them and, as a result, react more harshly to price
fluctuations than they would in other circumstances. When you inherit shares,
however, the previous capital gains are erased. This means that even if the
shares are stagnant, you still have a tax-free source of capital that you paid
nothing for. If they go down in value, you will get a tax write-off along with
the capital from selling them. If they go up, you have nothing to complain
about. Just because you have a cash cow, however, doesn't mean you should
slaughter it. Hold on to inherited shares until you need them or pass them on
yourself. (To learn more, see Inherited Retirement Plan Assets Part 1 and
Part 2.)
The Mechanics of Selling
The first thing to look at when selling an investment is the fees you are going
to have to pay. If you use a broker or hold the shares at a high-end brokerage
firm, there is nothing stopping you from transferring them to a discount
brokerage firm to limit your fees and increase your gains.
Taxes are your next concern. We have already discussed balancing out your gains
and losses to minimize your taxes. The last rabbit to come out of the hat is
the art of specifying shares. Sales are FIFO, or first in first out, unless
otherwise stated. For an investor with a stable portfolio, the FIFO method of
selling can be disadvantageous from a tax point of view. You always want to
sell the shares that you paid the most for and defer realizing the larger
capital gains on cheaper shares for as long as you can.
Let's say that you have a clockwork portfolio where you buy 50 shares of a
fictional firm called Harry's Edible Life Preservers Inc. (HELP) every year.
Over the course of four years, you pay $10, $15, $20 and $15 per share,
respectively.
Suddenly, you need $1,200 for an emergency and it just so happens that Harry's
shares are at an all-time high of $25. You decide to sell 50 shares. By
selecting the shares you paid the most for - the $20 ones - you can lessen the
amount of capital gain and, as a result, the amount of tax you pay. To do this,
you have to identify the shares by the date of purchase, or the purchase price
when you placed your order. Once again, you want to keep the shares that have
gained the most for as long as you can, then you can cash in when you retire or
have a tough year. By the way, shares of mutual funds aren't taxed like stocks,
but through a completely different system of average cost method (ACM), so
unfortunately you can't employ the same technique with mutual fund assets. (For
more on this topic, see How do you calculate the cost basis for a mutual fund
over an extended time period?)
Conclusion
Selling an investment is like buying one - you have to make sure it is in line
with your investing goals and then do your due diligence. Once you have decided
to sell an investment for the right reasons - either to balance your portfolio
or free up needed capital - the challenge becomes minimizing fees and taxes.
Your fees are best dealt with by finding a good discount brokerage to work
through, and your taxes can be kept in check by simultaneously realizing gains
and losses as well as specifying shares. Investing is not just about knowing
when to sell, but why and how to sell.
by Andrew Beattie