by Tyson Ray | CFP®, CEPA®, CIMA® Founding Partner, CEO, Senior Wealth Advisor
No one wants to pay more in taxes than necessary. But avoiding taxes shouldn’t come at the expense of sound investment decisions. What if avoiding a tax bill means taking on more risk than you intended? Or allowing a single investment to become an outsized portion of your portfolio? What if you hold onto a significant gain simply because you don’t want to pay the tax, only to watch some or all of that gain disappear?
That’s the distinction between being tax-avoidant and being tax-aware. Being tax-aware means understanding the tax consequences of an investment decision without letting the desire to avoid taxes drive the decision itself. Early in my career, I learned just how important that distinction can be.
When avoiding taxes came with a cost
I started my career in 1998, which meant my first couple of years coincided with the tech bubble. Tech stocks were producing extraordinary returns, and people were making money hand over fist. As some of those investments grew, I started having conversations with clients about taking some profit off the table. They had done very well. Maybe it made sense to reduce some of the risk and not to let one investment get too large.
One response came up time and again: I don’t want to pay the tax.
At the time, I understood the hesitation. Selling an investment with a significant gain can create a tax bill, and nobody gets excited about that. Then the tech bubble burst.
Clients who had substantial gains going into 2000 sometimes found that by 2001 or 2002, those gains looked very different or were gone altogether. That experience helped shape a philosophy I still bring to portfolio management today: Taxes should be part of our decisions, but they shouldn’t necessarily drive them.
Tax-aware, not tax-avoidant
There’s an important difference between managing taxes thoughtfully and trying to avoid them at all costs. Realizing an investment gain in a taxable account can create a tax consequence. The IRS explains how it treats capital gains and losses, including the distinction between investments held for more or less than one year. Understanding those rules and the potential tax consequences of an investment decision matters.
But so does understanding the risk of doing nothing. If one investment performed exceptionally well, it can eventually represent a much larger portion of your portfolio than originally intended. Holding onto it solely because you don’t want to realize a gain can leave more of your wealth dependent on what happens to that one investment.
Let your financial plan provide the context
At FORM, we seek to be tax aware. That means we consider the tax consequences of investment decisions while also asking what makes sense for the portfolio and your larger financial plan. We may look at whether an investment has grown out of proportion to the rest of the portfolio. We may consider opportunities to realize gains or losses thoughtfully. We may look at when you’ll need the money, what other assets you own, your risk tolerance, and the goals your wealth ultimately needs to support.
And if an investment decision is likely to create a meaningful tax bill, we can plan for that, too. We understand that sometimes the frustration around taxes isn’t about owing the tax. It’s about being surprised by it or wondering where the money to pay for it will come from. That’s a planning opportunity. Thinking ahead about potential tax consequences and the cash needed to cover it can make the experience very different.
This is also why investment decisions shouldn’t happen in isolation. Our investment management approach connects portfolio decisions to your goals, risk tolerance, time horizon, and the other details we discuss as part of your Life Plan™. Your portfolio has a job to do. Taxes are one consideration in how we manage it, but they aren’t its sole purpose.
Sometimes paying taxes means you made money
There’s a simple comparison I often use with clients. When you were working, and your employer offered you a pay raise, you probably didn’t turn it down because earning more money meant paying more taxes. You looked at what you would have left after taxes and recognized that you were still better off. There can be a similar mindset in investing.
If a portfolio has grown and created gains, taxes may be a part of the equation. Our job is to understand those consequences, look for opportunities to manage them thoughtfully, and weigh them against the investment decisions that may help grow, preserve, and diversify your wealth over time.
