Investing for the long term has many benefits. By identifying the stocks that will have bright prospects for years and even decades, you can maximize your chances of earnings explosive gains for your investment portfolio. Another big benefit of holding on to your stocks longer is that the IRS rewards long-term investors with reduced capital-gains taxes for investments held longer than a year.
Despite your best intentions, though, you'll sometimes find yourself wanting to sell a stock before you get past that one-year mark. If you already have paper profits on that stock, you'll face a tough decision: Should you sell now and pay higher taxes, or hold out for the lower long-term capital gains rate and hope the stock doesn't drop in the interim? Let's take a closer look at how you should think about that critical decision and the risks and rewards it entails.
Why long-term capital gains are such a big deal
Ordinarily, most investors prefer not to focus on tax considerations in making their investments. When you invest in an IRA or other tax-deferred account, you don't have to think about taxes, and that frees you to make buy and sell decisions irrespective of how long you've owned a stock.
But for taxable accounts, the difference in taxation of capital gains is truly huge. For taxpayers in the highest income brackets, each $100 of capital gains can cost you $39.60 in regular income taxes plus another $3.80 from investment-income surtaxes, adding up to a 43.4% rate on short-term gains. By contrast, the top tax rate on long-term capital gains is 20%, and although the 3.8% surtax on investment income still applies, a little patience can cut your tax bill almost in half.
Moreover, you shouldn't conclude that only wealthy taxpayers benefit from long-term capital-gains rates. Those who are in the 10% or 15% tax brackets generally pay their regular rate on short-term gains, but they don't have to pay any taxes at all on long-term capital gains so long as they remain in those tax brackets. Above that level, the 15% maximum rate on long-term gains for all but top-bracket taxpayers compares favorably with the 25% to 35% rates that apply to regular income and short-term gains.
Finally, some states have their own beneficial rates for long-term capital gains. In Massachusetts, for instance, long-term gains get taxed at the ordinary 5.2% rate, but short-term gains pay a higher 12% tax.
Finding the right balance between risk and reward
Ordinarily, these huge potential tax savings make holding a stock for the long run a smart move. But occasionally, you'll quickly earn a big paper profit on a stock just months after you buy it, and the resulting high valuation might make you nervous about hanging on to it long enough to pay lower long-term capital-gains taxes when you sell.
Resolving that dilemma doesn't have to be complicated, though. In general, if the reason you bought the stock hasn't changed, then even sizable short-term gains are usually just the tip of the iceberg compared to the long-term returns you're hoping to achieve. Selling early might make you feel good to lock in a quick gain, but it doesn't just boost your immediate tax bill; it can also lead you to miss out on a much larger long-term rise in the share price in the years to come.
On the other hand, if the fundamentals of a stock or other investment have changed, then selling early can mean the difference between earning any profit on your stock and suffering a loss. During the tech bust of the early 2000s, for instance, many investors were reluctant to sell highflying Internet and technology stocks because of the admittedly large tax bills they would have incurred by selling. In the process, though, many waited too long and ended up losing all of their gains and then some. It's always better to earn income that will be taxed than it is to give up that income entirely.
Overall, the incentive to hold on to investments long enough to benefit from lower capital-gains taxes on long-term holdings makes it worth thinking twice before selling quickly, as it really is usually worth it to wait. But if a truly game-changing situation comes up, don't hesitate to pull the trigger on a sale -- it can save you from even more costly losses.
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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.