Don’t Let the Tax Tail Wag the Dog
By Neil Rose, CFA
A short, honest conversation about common—and costly—mistakes smart people make with taxes.
We’ve seen it hundreds of times. A smart, successful person holds on to a stock far too long because selling would trigger a capital gains tax. The stock was up 400% at its peak. Then it falls. Now it’s up 30%—but they still won’t sell, because now the tax “doesn’t make sense.” Eventually, the stock is back to their cost basis, and they’ve lost years of potential returns, all to avoid a tax bill that would have been a fraction of the damage.
That is the tax tail wagging the dog.
Taxes matter. Of course they do. But they should be one variable in a decision—not the variable. Here are a few of the most common versions of this mistake:
Holding a concentrated position indefinitely. You retire with $4 million in company stock and a very low cost basis. The tax bill on selling feels enormous. So you hold. And hold. Meanwhile, all of your financial well-being is tied to one company’s fortunes. The answer is a thoughtful, systematic diversification plan—with a tax strategy built around it.
Buying muni bonds regardless of price. Many buy munis only because they’re tax free. This often leads to lower after-tax yields than an ordinary Treasury with the same maturity. Munis’ relative illiquidity and higher trading costs often go unconsidered. For munis, it’s better to seek advice from an advisor or broker/dealer with real expertise.
Buying muni bonds in the wrong bracket. This is another way investors mistake the yield they are actually receiving. If you’re in the 22% or lower federal bracket, a taxable bond often beats a muni on an after-tax basis. Munis are inherently more valuable the higher your marginal tax rate is.
Investing in bad deals for good tax reasons. Opportunity Zones. Oil and gas deductions. Some are excellent, but some are mediocre-to-bad investments dressed up in tax clothing. Always run the investment through a non-tax filter first. Ask: Would I own this if there were no tax benefit?
Over-funding whole life insurance for tax-free growth. The internal costs of these policies are high—sometimes ridiculously high. The returns should be evaluated honestly against alternatives. “It’s tax-free” is not a sufficient answer to, “is this a good use of my capital?”
Assuming future tax risk. This is something many professional, mid-six-figures earners make: they only consider lowering their present tax bill and load all their savings in tax deferred vehicles like 401(k) and SEP-IRAs. While there are tax benefits today, there’s risk that their income will be eventually taxed at a higher rate because they underestimated the chances that inflation, income, and/or higher than expected federal and state tax rates in the future. Remember, non-Roth retirement vehicles are tax-deferred, not tax-free. Meanwhile, tying up all savings in retirement plans means lower flexibility and ability to seize opportunities in real estate, private investments, and even opportunities to expand their own business. Opportunity cost is a big cost most never consider.
The Buffett Rule (Our Version):
“The best tax shelter of all time is a great investment.” Don’t contort your portfolio into unrecognizable shapes trying to avoid taxes. A well-diversified, well-managed portfolio that grows steadily will always outperform a tax-optimized portfolio of mediocre investments.
The hierarchy is this: invest well first, then optimize for taxes within that well-invested portfolio. The reverse is letting the tax tail wag the dog.
This material is for informational purposes only and does not constitute tax or legal advice. Please consult your tax professional for guidance specific to your situation.
About the Author
Neil Rose, CFA, is the founder and CEO of Regency Capital Management.
