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Don’t Let the Tax Tail Wag the Dog

When you’ve been writing about finance and investing as long as I have, you make a lot of friends within the industry. And over the years, a surprising number of mine have made the financially prudent choice to trade in their “press” hats for financial planner certifications. (I personally think the hats are cooler.)

Just the other week, I was telling one of my CFP pals a wild story about a mutual friend who put $10,000 into dogecoin at the beginning of 2021 — yes, dogecoin — and rode it all the way up to a huge six-figure sum.

(If you don’t know about dogecoin, your friends are probably better investors than mine. It’s basically a cryptocurrency that started out as a joke until a small group of people started taking it very seriously. All the craziness of the GameStop short squeeze, but with crypto.)

“But that’s not even the craziest part,” I said incredulously. “He refused to sell. He didn’t want to pay the capital gains tax on it!”

“Ahhh,” said my CFP friend, knowingly. “He’s letting the tax tail wag the dog. You see it all the time.”

Maybe you’ve heard the expression “let the tail wag the dog” before. If you haven’t, it’s usually used to refer to scenarios where a small or unimportant factor (the tail) ends up becoming more important than the thing it’s a part of (the dog).

When it comes to finances, letting the tax tail wag the dog means making financial decisions primarily to avoid taxes, rather than focusing on the overall health and goals of your financial plan.

This could involve refusing to sell a risky investment to avoid capital gains tax, making irrevocable gifts to reduce estate taxes, or any number of strategies where the primary motivation is tax avoidance.

My friend missing out on his once-in-a-lifetime jackpot just because he didn’t want to sacrifice 24% of his profit to capital gains tax? Tax tail wagging the dog.

Now, you don’t need to be a CFP to know how ridiculous that is. No matter how big a gain is, the capital gains tax is just a percentage of the profit. Even after you pay it, you still have more money than you started! And when you’re dealing with an asset as ridiculous and volatile as dogecoin, it’s almost always best to take the money off the table after a big win.

Case in point, had our crypto friend cashed out his dogecoin near $0.70 per coin — when I was shouting at him to “take the money!” — he would have owed $31,200 in short-term capital gains tax on his $130,000 profit, for a net gain of $98,800 in less than five months. Not bad!

However, he wanted to hold out until he qualified for the long-term tax rate. While he was waiting, doge fell back to around $0.15 per coin, where it has pretty consistently remained. Selling at that price — but with the more favorable long-term capital gains cost — he’d be looking at a $20,000 profit and a $4,500 tax bill, for a net gain of $15,500 over a year. Also not bad!

…but if I had to pick, I’d still take the short-term tax rate and $98,800.

Like my CFP friend said, this exact scenario happens all the time. Someone makes a less-than-prudent financial decision just because it results in a lower tax bill.

And while taxes are certainly an important consideration, they should not dictate your entire financial strategy.

When it comes to investing and managing your finances, it’s easy to get caught up in the fear of paying taxes. Many investors find themselves making decisions based solely on tax implications, often leading to unnecessary risks and potentially poor financial outcomes.

Why Do People Dread Taxes So Much?

Look, I get it. Taxes are never fun to pay, especially when it feels like a significant portion of your hard-earned gains are being taken away.

This dread often leads to bad financial decisions. People who are normally logical and risk-averse can find themselves in precarious financial positions simply because they want to avoid paying taxes. They might hold onto a single investment for too long, increasing their risk exposure, or make hasty financial moves that aren’t aligned with their long-term goals.

Consider two hypothetical investors, Alice and Bob. Both purchased the same stock 10 years ago, which has since appreciated significantly.

• Alice's Approach: Alice decides to diversify her portfolio despite the potential tax hit. She sells part of her stock, pays the capital gains tax, and reinvests the proceeds in a diversified portfolio of stocks, bonds, and real estate. Over time, her diversified portfolio grows steadily, and she sleeps soundly knowing her risk is spread out.
• Bob's Approach: Bob, on the other hand, can't bear the thought of paying the taxes. He holds onto the stock, even as it becomes an increasingly large part of his portfolio. One day, the stock’s value plummets due to unforeseen circumstances, wiping out a significant portion of Bob's wealth. Bob is left wishing he had diversified earlier, even if it meant paying those dreaded taxes.

To avoid letting the tax tail wag the dog, consider the following tips:

1. Focus on the Big Picture: Your overall financial health and long-term goals should be the primary drivers of your investment decisions. Taxes are important, but they are just one piece of the puzzle.
    
2. Diversify Your Portfolio: Don’t let fear of taxes keep you from maintaining a well-balanced and diversified investment portfolio. Spread your investments across different asset classes to manage risk effectively.
    
3. Seek Professional Advice: Work with a financial advisor who can help you navigate the complexities of taxes and investments. They can provide strategies to minimize taxes without compromising your financial goals.
    
4. Plan for Taxes, Don't Fear Them: Understand that paying taxes is a part of investing. Rather than avoiding them at all costs, plan for them as part of your overall financial strategy. This might mean setting aside funds to cover taxes or exploring tax-efficient investment options.
    
5. Stay Informed and Flexible: Financial markets and tax laws can change. Stay informed about these changes and be flexible in adjusting your strategies as needed.

While it’s natural to want to minimize taxes, letting the fear of taxes drive your investment or business decisions can lead to unnecessary risks and missed opportunities. By focusing on the bigger picture and incorporating sound financial planning principles, you can ensure that your investments serve your long-term goals, not just your short-term desire to avoid taxes. Remember, the dog (your overall financial plan) should be wagging the tail (tax considerations), not the other way around.