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Tail Wagging

Kenyon Sayler

A POPULAR REFRAIN is that we shouldn’t let the tax tail wag the investment dog. I struggle with this one.

Currently, 87% of our stock portfolio is in broad-based, low-cost index mutual funds, with the other 13% in individual stocks. I prefer the index funds—and yet I continue to hold the individual stocks because I don’t want to pay the taxes on our gains.

About 6.7% of our total stock portfolio, equal to half our money in individual stocks, is in my former employer’s shares, which I received as part of my compensation. Over the years, I’ve worked diligently to keep our holdings below 10%.

Our next largest individual holding is Target Corp., at about 2.8%. When my wife picked me up from work on Oct. 19, 1987, all of the news was about the stock market. The Dow Jones Industrial Average had crashed 22.6%. On the drive home, I asked my wife what she thought we should do. She promptly replied, “Buy Dayton Hudson.”

Dayton Hudson was our local department store. Its major division was its Target discount stores. Being a young couple, we shopped at Target, so the next day I bought 100 shares of Dayton Hudson. The department stores are long gone, but Target lives on.

Between our initial purchase and reinvested dividends, our cost basis is now $13.80 a share. Yesterday’s closing price was $149.36 (symbol: TGT), almost an 11-fold increase. Although I’d like to unload the stock and put the money in an index fund, the thought of paying the taxes—even at the long-term capital gains rate—has kept us from selling.

Our third largest holding is McDonald’s, representing about 2.5% of our portfolio. In late 1981, I bought a single share of McDonald’s and enrolled in its dividend reinvestment plan. That gave me the ability not only to reinvest the dividends in additional shares, but also to send McDonald’s money to buy more stock. For many years, I purchased $50 of McDonald’s stock every quarter. As my salary grew, the amount I invested also grew, eventually reaching $150 a quarter. Our cost basis today is the equivalent of $51.80 a share. Yesterday’s close was $252.42 (MCD), almost a fivefold increase. Again, I have a hard time selling the shares and paying the long-term capital gains taxes.

We own three other individual stocks, each less than 1% of our assets, but each showing nice gains. So, what am I doing?

I sold some of my employer’s shares that were showing a loss. I also sold all of our Novartis stock, which had “only” doubled in price. The loss offset the gains, so the trades didn’t increase our tax bill. I’ll use the proceeds from the sales to buy more of our index funds. That’s a small step toward eliminating the individual stocks in our portfolio.

I’m not sure that I’ll ever sell the Target and McDonald’s shares, and trigger long-term capital gains taxes. My plan right now is to die holding them, and let my children inherit them at a stepped-up basis. They can then sell them and invest the proceeds in a well-diversified portfolio.

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John Wood
John Wood
2 months ago

While you’d incur an appreciable tax bill if you sell, it may be comforting to know that you’re owning Target, McDonalds, and your other companies in the most tax-efficient way possible. You pay tax on the dividends each year but, otherwise, your 11- and 5-bagger returns have accrued to you tax-free.

Even the Vanguard 500 Index Admiral Shares (VFIAX) loses annual return to taxes (as of 6/30/2022, the 10-year, pre-tax AAR was 12.92%, while the return after taxes on distributions was 12.42%, for a 3.86% annual tax drag on returns).

It sounds like you’re well diversified with Index funds — I’d hold the individual stocks and enjoy the tax-efficient compounding.

Joey
Joey
2 months ago

I’m curious to know that, since these 11- and 5-fold increases have occurred over so much time, if your Target and McDonald’s stock holdings have outpaced a broad index fund. Do you know?

David Sayler
David Sayler
2 months ago
Reply to  Joey

Unfortunately, I don’t know that. Since I’ve reinvested dividends and added principle over time, I don’t have a clean way to figure out if they have done better than the S&P500.

wtfwjtd
wtfwjtd
2 months ago

Maybe if you hold your individual stocks long enough, they’ll become the next Enron, World Comm, or Sears. Problem solved! No more worries about capital gains taxes 🙂

David Sayler
David Sayler
2 months ago
Reply to  wtfwjtd

That is basically what happened to my GE stock. I made a slight gain, but nothing like I would have had I sold earlier….

parkslope
parkslope
2 months ago

Biden’s American Families Plan would have eliminated the stepped-up basis while including a $1 million capital gains exclusion ($2 million for couples). His proposal didn’t make it through the House Ways and Means Committee last fall. However, I think we can expect this issue to be revisited in the not too distant future.

R Quinn
R Quinn
2 months ago

Does this mean 100% of your current investments are in equities one way or the other? I too kept all my former employer stock received as compensation but I also use different types of bonds.

Jo Bo
Jo Bo
2 months ago

Another thought is to use appreciated shares for charitable giving. And, might your wife want to write for this site?

David Sayler
David Sayler
2 months ago
Reply to  Jo Bo

We did fund our Donor Advised fund with appreciated individual stock. It should run out of funding about the time I need to take RMDs from my IRA – so we’ll use the Qualified Charitable Distribution then.

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