This Capital Gains Tax Trap Can Ruin Your Portfolio

Nobody wants to pay capital gains tax. It reduces your total return and takes away investing capital that could otherwise grow and multiply over the years. But especially with capital gains tax, you have to be careful not to let your tax considerations dominate your decision-making process with your investment portfolio. Otherwise, you could easily find that your efforts to avoid capital gains tax are successful only because the capital gains themselves disappear. Let's take a look at a couple of instances in which capital gains tax considerations can lead you to make huge mistakes with your portfolio.

Source: Phillip Ingham, Flickr.

Scenario 1: Trying to make it to the one-year mark
One aspect of capital gains tax avoidance involves holding on to your stocks or other investments long enough to qualify for beneficial long-term capital gains tax treatment. If you hold a stock for a year or less, then any gains you realize when you sell will get taxed at your ordinary income tax. Under current law, that means losing as much as 39.6% of your gains to tax, along with an additional 3.8% in net investment income surtaxes that further increase your overall tax burden. But if you extend your holding period to at least a year plus a day, then the long-term capital gains tax rate that applies is much more beneficial. Low-bracket taxpayers actually pay 0% in capital gains tax, while those in middle brackets pay a maximum of 15% and top-bracket taxpayers get a 20% rate.

Obviously, with the opportunity to cut your capital gains tax by half or more, the temptation to hang on to a winning stock longer is greater. But there's no guarantee that the stock price will cooperate with that strategy.

For instance, over the past couple of months, investors have seen an exodus away from former high-flying momentum stocks. Many companies that had seen huge share-price advances over the past year have suddenly reversed course and fallen dramatically. If you had bought those stocks almost a year ago and were waiting to get better capital gains tax rates, you would have seen a lot of your paper gains go up in smoke.

Scenario 2: Holding on to fading businesses all the way down
The one-year rule for long-term capital gains tax is important for shorter-term traders. But even if your ideal holding period is forever, the capital gains tax trap can strike and lead you to make bad decisions about stocks whose best days are long behind them.

Two very common examples in many older investors' portfolios are tech stocks Microsoft and Intel . Both of those stocks hit their all-time highs during the tech boom of the late 1990s, and ever since, Microsoft and Intel have struggled to regain their former glory. In the case of Intel, the slow but steady move away from PC-based computing devices toward tablets, smartphones, and other mobile devices over the past decade has threatened Intel's core business, and Intel's efforts to move aggressively into the mobile-device space have been late in coming and haven't had the impact that long-term investors have wanted to see. Microsoft similarly coasted on its dominance in PC operating systems and office software throughout the 2000s, and it allowed competitors to take the lead in adapting to the mobile world. Microsoft has recently rebounded sharply on hopes that it will successfully foster its offerings in high-growth businesses like cloud computing. But neither Microsoft nor Intel have a certain future, and for those who foresaw competitive pressures but held onto their shares to avoid capital gains tax, their holdings of Intel and Microsoft shares have essentially been dead money since 2000.

Paying capital gains tax always seems like a waste of money. But sometimes, it's the best way to preserve your investment gains. If you're too stingy with the tax man, you might end up missing out on those hard-earned gains entirely.