Taxes on Investments: What You Need to Know

By Michael Cintolo, Vice President of Investments and Chief Analyst Cabot Market Letter and Cabot Top Ten Trader
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I want to touch upon one of the big bugaboos with investors—taxes on investments. I regularly talk to subscribers who say something to the effect of, "I can't sell that; I've owned it since 1997 and will have to pay huge taxes if I sell!"  And as we approach the end of the year, I inevitably hear "I can take that loss—I have gains to offset anyway."

This is not the correct way to think about taxes on investments. The trick is to think about taxes before you invest, not when you’re thinking of selling.

Now, you might be thinking "Thanks Mike. Just the thing I want to think about more—taxes on my investments." But I began figuring taxes into my thinking a couple of years ago, and it's helped tremendously.  

Before you do this, you must make an assumption. You have to believe (really, know) that you're going to make money over time. Not every month, not even every year, but you must have the conviction that you're not going to be carrying losses over for years at a time.

With that in your back pocket, you should also know your marginal federal and state tax rates. An average investor in Massachusetts might be paying a 28% Federal rate, plus a sobering 12% short-term capital gains tax to the state.  

Translation: 40% of every dollar made in the market (assuming you hold the stock less than a year) goes to the government. To most, this would seem to be a stunning figure ... it might even make you want to skip investing altogether.  But it's no big deal, as long as you consider the consequences beforehand.

Given the figures above, you should be investing more than you normally would. Stop thinking of a $5,000 profit as a $5,000 profit—it's really a $3,000 profit (assuming a 40% tax rate). And the same goes for losses; a $5,000 loss is really only a $3,000 loss.

Or, said another way, if you double your money in a stock, the reality is actually much less, because Uncle Sam is going to take 40% (in this example) of that profit. The same goes in the case of a loss, over the long-term, because your losses will be used to offset your gains.

All of this is a way of saying that you really have less money at risk then you think—win or lose, the government is going to take a significant chunk.

Thus, you should be taking taxes into account when investing, and the proper time to do that is before you buy a stock, i.e., when you're deciding how many shares and how much money to invest in the first place.

Disclaimer: I am not a financial advisor or tax consultant (thankfully!), so do your own due diligence when it comes to your tax status.  And, of course, the above cannot be taken to extremes—you can't lose all your money, for instance, and then cheerfully say, "Gee, I only lost 60% of it because of tax loss breaks!" That's insane.

As a general rule, you shouldn't risk more than 1% or 2% of your portfolio after taxes, at most, on any single trade. I personally tend to keep my risk around 0.5% or sometimes less.  

But my main point is to consider the taxes before you invest—if you do, you'll have a truer grasp of your portfolio.

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