Selling Today to Save on Taxes Tomorrow Is a Dumb Idea. And I'll Prove it.

Jason is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Popular Wisdom holds that "there is only one reason to buy, but many reasons to sell."  And while this is usually in reference to insiders, it carries over to individual investors as well.  As a matter of fact, I wrote this article a couple of weeks back, describing how taxes is one reason to sell for some individuals, myself included. 

And there's the so-called "Fiscal Cliff" now fast approaching, casting doubt over a holiday shopping season that already has investors and business owners on edge.  Obamacare is now a reality, increasing costs for medical device manufacturers in 2013, creating uncertainties for small and medium-sized businesses, and adding expenses at the state and federal government levels.  And while the past four years has seen a net increase in jobs, even after coming through arguably the toughest economic climate in 8 decades, many of these jobs are part-time or low-paying service industry jobs, not the high-income jobs the country needs to see sustained growth.  Did I mention Europe is dying and China isn't growing very fast anymore?

There is so much uncertainty out there, and cashing in, getting today's cheap capital gains rates, and then reinvesting when the world isn't going to end is a smart call, right?  Why would anyone want to be in the market right now? 

It's really simple, actually. 

In the long-term, all of the uncertainty above is just noise.  It will have very little- if any -impact on long-term investors, if we just stay the course.  There is just as much to be optimistic about. There is evidence of a burgeoning recovery in the housing market, and with new home starts well-behind population growth, it looks to be sustainable and accelerating.  The U.S. is a net exporter of oil, and projections are that we will be the largest producer in the world within ten years.  Combined with a rapidly growing natural gas boom, as this resource becomes a viable fuel for the transportation sector, and we may have a major driver of high-paying jobs and a boon for the U.S. economy that we haven't seen in decades. 

So what's up with the headline?

Fair enough.  The bottom line is that while all the headlines talk about a lot of uncertainty, the reality is that much of that uncertainty is just noise, and it doesn't make for long-term success to respond to all that noise.  However, I think that most of us can rightly predict that Capital Gains taxes, at historic-low rates right now, are fairly certain to increase in the future.  With that said, if you have owned any of the following 5 companies for the past 5 years or longer, you may be considering selling before the end of the year in order to minimize future taxes, and lock in strong gains:

AAPL data by YCharts

Apple (NASDAQ: AAPL) has been one of the greatest investing stories of all-time, for those that have owned shares for five years or more.  Amazon (NASDAQ: AMZN) has rewarded shareholders as well, as the world's largest bookseller is rapidly expanding in scale, and in many homes (mine included) is becoming the go-to retailer for almost any consumer good you can imagine.  These two companies have been rewarding shareholders for more than a decade, and frankly it doesn't look to be slowing down for either company any time soon. 

Chipotle Mexican Grill (NYSE: CMG) and Starbucks (NASDAQ: SBUX) have similarly rewarded investors.  Chipotle may be younger and smaller, but they both still have significant growth ahead for their core brands.  And with both companies expanding their breadth and offerings, long-term shareholders should continue to be rewarded. 

Rackspace (NYSE: RAX), competing with Amazon in the web services business, and renowned for their "Fanatical Support," is still years away from the potential scale it could achieve. 

And while there are risks with all five of these companies, and the future is not certain, ever, for anything, there is really only one reason you need to consider, as to why selling to take advantage of today's tax rates is probably not the right thing for you to do. 

It's the time value of money. And this is where I'll prove why you are making a mistake to sell now. 

From Wikipedia:

"The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money is the central concept in finance theory."

Let's assume that we are selling securities that will net $100,000 in income.  So that means, based on long-term capital gains taxes, I am taking $15,000 of that money and losing it now to save taxes later.  I will never have to pay taxes on the remaining $85 grand.  It will forever be part of my cost-basis, whether I choose to re-invest it into the five companies above (after having allowed enough time to pass before re-acquiring shares,) or another company completely. 

On the surface, that's a pretty good deal, right?  Especially if Capital Gains taxes increase sharply.  Let's do a quick calculation and see what the numbers say:

So how does it affect me, someone that's 20 years from needing that money?  Let's compare how $100 grand grows over two decades, to how $85,000 grows.  To keep things simple, let's operate under the assumption that the invested capital matches the market's average annual return (@7%) over the past century:

$85,000 would grow to $344,000, while $100,000 would become, $405,000. 

Simply put, by cashing in today, based on a fictional future tax rate, I cost myself $60,000 in potential returns. 

It could be a lot more.  The fact is that all of these companies have all absolutely destroyed the market.  At "only" 10% annual returns, selling to lock in today's "low" tax rate would cost you over $95,000 in returns.  I don't know about you, but an extra hundred grand in retirement would sure come in handy.  Even in the short term, it can cost investors a lot of money:  Only five years from now, it would cost nearly $10,000, and a decade away, more than $25 grand.  It's the magic, to paraphrase Warren Buffett, or Peter Lynch (it actually may be my high-school algebra teacher) of compounding interest. 

In summary, the biggest advantage the individual investor has is time.  And we must use this time to maximize our resources, and keep as much of our hard-earned money invested in strong companies as we can.  And sometimes this means taking a step backwards, and making sure we are doing the right thing today based on the long view.  And selling at a loss today to reduce today's taxes may make sense, as I discussed in the article linked near the top.  But selling big gainers today to pay today's tax rate on tomorrow's money is rarely the smart call.  

Now get out there and find out if I'm telling the truth.  After all, it's you're money, and I'm just some guy with a blog. 


elihpaudio owns shares of Apple, Amazon.com, Chipotle Mexican Grill, Rackspace Hosting, and Starbucks. The Motley Fool owns shares of Apple, Amazon.com, Chipotle Mexican Grill, Rackspace Hosting, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Apple, Amazon.com, Chipotle Mexican Grill, Rackspace Hosting, and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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