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Should You Sell Your Stocks for the Tax Refund?

Author: Brad Howland
First Posted: Dec. 1, 2008

The recent bear market has spawned a number of articles on the web debating whether it's a good idea or not to sell stocks before Dec. 31, realize the capital losses, and use them to reduce income tax for the year. I feel that it's a bad plan for most of us.

Are you a stock trader, or a long-term investor using a buy-and-hold strategy? Most people should invest with a long-term time frame in mind—at least 5-10 years—as this strategy has proven to be the best way to make money in the stock markets. It makes no sense to me for this type of investor to sell stocks beaten down by the market just to realize a short term tax benefit.

The problem is that the net tax benefit is so small, compared to the loss you have to realize. To take a simplified example, suppose a single individual earns $60,000/year, had a $2,500 gain in his/her portfolio early in 2008, incurred substantial losses on paper later in the year, and now wants to sell enough stock to write off against the capital gain.

If the taxpayer lives in Canada, he/she would pay tax on only 50% of the capital gain. For a BC resident the combined federal/provincial tax on the gain would be $2,500 x 50% x 29.98% = $374.75. The taxpayer can write off up to $2,500 of capital losses against that gain (in Canada capital losses can only be applied against capital gains, not against ordinary income), but only 50% of capital losses are deductible, so he/she would need to take a $2,500 loss to save that $374.75 in tax, a tax savings rate of about 15% ($374.75/$2,500).

If the taxpayer lives in the United States, on the federal level long-term capital gains are taxed at a lowered rate of 15%, but state taxes must also be considered. If he/she is a California resident the combined federal/state taxes on the gain would be in the area of $636 or so: call it 25% of the gain. Taking a loss of $2,500 at year-end would reduce that tax down to nil for a 25% tax savings, but life in the US has the additional advantage of being allowed to deduct up to $3,000 of capital losses against ordinary income. So, if the taxpayer took, say, $5,000 of losses at year-end, they would save something in the area of $1,500, or a 30% savings rate on the loss ($1,500/$5,000).

Are you with me so far? Why would a buy-and-hold investor, who expects his/her stocks to rebound in the long-term and provide a reasonable return, convert their current paper losses into real losses by selling now, when the tax benefit is so small? An investor in the situation described above might achieve in Canada 15% of the losses taken in tax savings, in the US 25-30%, but remember that California has one of the highest state tax rates in the union: results will vary depending on where the taxpayer lives. Wouldn't that investor prefer to wait for his/her stocks to recover? It's much better for most taxpayers to sell at a gain, earn the income and pay tax on it, than it is to sell at a loss in order to reduce tax.

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