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Three Costs to Selling Stocks

My favorite tax document is no tax document - especially when it comes to a 1099 from a brokerage account. Yes, income is good because your investments made money, but if you’re young, you want your income to be in the form of unrealized gains since these are deferred from income tax.


An ‘unrealized’ gain means the value of your investments went up, but you haven’t sold them yet to ‘realize’ that increase in value. This acts as a deferral of income to let your investments continue to grow on themselves, known as compounding. Letting your investments grow tax free without having to lock it up in a retirement account is amazing!


There are times when it may make sense to sell investments, but here are three benefits to not selling your stock holdings:


1. Taxes


We all love our retirement accounts because of tax deferral - but why don’t we create tax deferral in our taxable investment accounts by holding on to the investments?


Typically, selling a position means you made some money and you want to take profits. There are plenty of other reasons to sell positions, but I’m keeping this very simple with the point; any time you sell, there is a tax consequence.


This is a cost! You’ll come out of pocket to pay the taxes on the gain. This is either in the form of:

  • Taking money out of your brokerage account from the proceeds of your sale. This leaves less money to invest, and thus less compounding growth over the long term. You worked so hard to get that money in there, it is advisable to keep it in there.

  • You can pay out of a checking or savings account to cover the taxes created in your brokerage account. But, there is an opportunity cost to this since that money is no longer available to do something else (like more investing!).

Taxes aren’t so bad, especially because it means you made money. But, selling can inhibit the compounding growth by adding a tax drag to your accounts.


Additionally, taxes can be in a different form than the standard percentage tax rate on income. By selling investments, you may also:

  • Phase yourself out of the Earned Income Tax Credit

  • Trigger the Net Investment Income Tax

  • Increase the taxable amount of your Social Security income

  • Lose health insurance premium subsidies or increase Medicare premiums

  • Create interest and penalties if you don’t pay estimated taxes

  • Increase student loan payments on an income driven plan, or phase yourself out of interest deductions

These are a few examples of how your income affects many other variables in your finances beyond just your marginal tax rate.


The true cost of trading a position may be more than you realize. An advisor or tax expert can help give you an idea of all the things that are affected by your income and what the sale of something truly means - and how you can potentially change or avoid that outcome.


2. Transaction Costs


This is probably a smaller cost, but important nonetheless. As much as we like to think that downloading Robinhood and placing trades is free on all fronts, unfortunately that not the case. There are two major costs that occur every time you place a trade:


Commissions


Robinhood helped us all out by being the leader of $0 commissions in trading. Many of the larger brokerages followed suit and went to $0, so things seem totally fine, right?


Unfortunately not. Maybe for most equity and ETF trades, but if you are trading options or mutual funds, there is almost always a fee to get in and out of the positions every time you do so.


One other commission is what is called a “load” - these are uncommon, but still occur in certain funds. A load is charged by some mutual funds, which can be considered a front or back-end load - this is just a commission by way of charging to get into the position (front-load) or to sell out of the position (back-end load) and is administered by the fund company, not the brokerage company. Be careful of these mutual funds in your retirement accounts, and make sure you understand all the fees when getting in and out of positions.


Payment for Order Flow


This is the secret behind commission free trading. We all know Robinhood gets paid…. a lot. Now that they are a public company, I can tell you they made about $960mm of revenue in 2020. That doesn’t sound free….


They sell their trades to a third party, and receive payment for doing so. Hence, payment for order flow. This isn’t a bad thing, but it is a cost. Third parties will pay for that order flow because they make money on the spread, which is created / paid by traders.


As a broker, the third party is in control of brokering the exchange between a buyer and seller. So, the seller wants to sell their share of Robinhood for $20 and the buyer wants to buy a share of Robinhood for $20.02. The third party puts these two together, delivers one share of Robinhood to the buyer in exchange for $20.02, and pays $20 to the seller in exchange for their Robinhood share. The third party pockets $0.02.


That $0.02 spread is tiny for one share, but imagine this every time you bought or sold - a little piece is staying with the broker every time you trade, which creates a “cost” because that money never made it to you.


3. Time / Opportunity Cost


This one is simple, so I’m going to make it brief. How much time would you have to spend researching and watching your portfolio everyday to make decisions on your investments?


The answer is a lot.


It is much simpler to have everything automated and investing in funds that automatically keep your investments diversified.


Time is one of the most limited resources, and it takes a lot of it to stay on top of the markets and your investment accounts as an active trader.


Simplifying your strategy and focusing on adding money to the portfolio is a huge time saver and stress reliever. CNBC is out there to keep you watching the volatility of the markets, but the sooner you can forget about your portfolio and let it work on its own, the sooner you’ll have freedom with your money in the form of time and stress.


Isn’t trading necessary for rebalancing?


Maybe for retirees, but not young professionals. Your goal should be to rebalance with new portfolio contributions so that there is no tax impact.


In other words, if your US equity holdings did amazing and are now overweight relative to your international holdings, there is no need to sell your US equities, realize gains, and then redistribute elsewhere. Instead, you can leave the US equities so that there is no tax impact (since this remains ‘unrealized’) and use any new contributions into your portfolio to invest more aggressively into your international holdings, until the portfolio is back to your targeted allocation.


Once your portfolio gets to a certain size this may not be possible, but then it may be time to hire a professional rather than read a blog :)


Final Thoughts


There are pros and cons to any strategy, but so much data and research points to the benefits of being a holder of investments over the long-term; and these costs I outlined above are just a few of the financial reasons to do so.


I say this often, but the stock market should not be used as a creator of wealth - creation of wealth comes from the discipline of spending less than you make and saving into the most efficient accounts for your situation / goals.


The stock market should be used to grow the wealth you’ve created. It takes a lot less time and energy to do this in a passive way than being an active trader trying to find the next big winner.


The simplicity of this strategy is really appealing beyond just the cost savings. I think we should stop making investing so complicated, and focus on setting up the simple and effective strategies that have proven time and time again that they are cheaper, easier to understand and yield better results.


Here is a nice segue for you; one final cost of trading stocks may be the need for a tax preparer. Taxes are coming up quickly, and if you need some advice or somebody to prepare your tax return that has expertise in investments, feel free to reach out to me!