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Course 304
Strategies for Selling

Introduction

You've decided that yes, you need to sell an investment from your portfolio.Selling a loser is no problem for most investors (though we'd advise against selling an investment simply because it's down--further investigation is almost always warranted). But what about an investment where you've made a few bucks? If you're selling the investment from a taxable account, Uncle Sam will be right behind you with his open hand.

The idea of paying taxes on investment gains shouldn't stop you from selling securities that you want to sell. But you need to realize what the tax consequences of any sale would be. By putting off a sale, you may be able to save a bundle in taxes.

Here's how to figure out how much appreciation you're sitting on, the scenarios where you'd probably be best off accepting the tax consequences, and where delaying a sale might be the better choice.

Just How Big a Gain Are You Looking At?

Calculating your basis, or the combination of cash paid plus any dividends reinvested that have already been taxed, is no easy task.

First, find the purchase date (or dates, if you bought the fund or stock over a period of time) and price (or prices). Next, find out how much of your gain has already been taxed as dividends (assuming that you've reinvested those dividends in the stock or fund) for each year since you've owned the security. The difference between the value of the investment today and the basis is your capital gain.

When to Sell and Accept the Tax Consequences

Many investors find that their need to sell overrides any tax issues. Here are some cases where going ahead and selling is probably the best option:

If you've held the security for at least one year. If you've held the security that you want to sell for at least one year, you're eligible for long-term capital-gains rates. Long-term capital gains are taxed at a lower rate for most investors; see the IRS's web site for current rates. Meanwhile short-term gains--or gains made on securities held for less than one year--are taxed at ordinary income tax rates, which are higher.

If you can engage in tax-loss selling elsewhere in your portfolio. Tax-loss selling is a way for investors to manage the amount of taxes that they pay on their investments. In tax-loss selling, you sell investments thathave lostvalue to offset the gains that you're taking on winning investments.

But beware: Selling a losing position to offset gains in a winning investment can be a smart tax decision, but a poor investment decision. If you do tax-related selling, sell investments that you'd likely sell even if taxes weren't an issue.

If you have a long time horizon and can compensate for the tax cost of selling over time. For those with a relatively long time horizon, say 15 years or more, consider selling part or all of your appreciated shares, taking the tax hit, and reinvesting in other securities. Because you have so much time to recoup the money you're losing to taxes, selling may outweigh the tax costs.

If your portfolio is way out of balance because of this investment. You should have an establishedasset mix for your portfolio. How far off is your current allocation from that target because of this security? The farther off you are, the more benefit you'll gain (in terms of risk control) if you sell at least some of your investment.

If the stock or fund really isn't you. Let's say you made a killing on a stock three years ago only to experience a sickening drop this year. You learned thatinvesting in such heated marketsjust isn't for you, no matter how high the highs can be.

The riskier the investment (and that includes "price risk" in overheated markets), the better off you'll be by selling and diversifying away some of that risk.

If you're convinced bad times are ahead. Most investors would agree that it's better to take a gain on an investment than to take a loss.If you just think nothing but losses are in this investment's future, then sell.

When to Think About Waiting

Sometimes it may pay for you to hold on to a sell candidate, at least for a while longer.

If you haven't owned the stock or fund for at least one year. If you haven't held the investment for at least one year, you'll be subject to short-term capital-gains rates on your sale, which can be dramatically higher than the long-term capital-gains rate. Soconsider waiting to sell the security until you've passed the one-year mark.

The stock or fund has consistent performance and is not overly volatile. You may want to sell an investment because a new opportunity has presented itself, or because its growth is slowing. But if this is only a moderately risky investment, consider whether you really need to sell it. How bad are things likely to get? So bad that the tax consequences are worth it? Perhaps not.

The investment isn't messing up your asset allocation or threatening diversification. If the investment that you want to sell takes up only a small portion of your portfolio and isn't throwing your portfolio off-kilter, you may not need to sell immediately. Consider selling a little bit of your position each year, thereby minimizing the tax hit.

You just can't take a big capital-gains tax hit right now. Look at the rest of your financial life. Perhaps you exercised some incentive stock options and have to pay Alternative Minimum Taxes this year. Or you have fewer write-offs than usual. Or you'll be paying estate taxes soon. Now may be a bad time to add capital-gains taxes to the mix.

Quiz 304
There is only one correct answer to each question.

1 What is your basis composed of?
a. How much you paid for the investment
b. Dividends that you've reinvested that have already been taxed
c. A combination of A and B
2 If an investor has held a security for less than one year, what rate will an investor's capital-gains be taxed at?
a. It depends on the investor's ordinary income tax rate.
b. The 35% rate
c. The long-term capital gains rate
3 What is tax-loss selling?
a. Selling an investment and paying taxes on it
b. Selling investments that you've lost money in to offset the gains you're taking on winning investments
c. Waiting to sell an investment until you're in a lower tax bracket
4 When should you think about selling at least part of an investment immediately?
a. If it's throwing your asset allocation of out whack
b. If it takes up a small part of your portfolio
c. If it's a consistent, low-risk investment
5 When might you consider waiting to sell an investment?
a. If you've held the security for less than one year
b. If the investment is in an overheated area of the market
c. If the investment really isn't you
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