Don't get trapped by tax dodge

'People who complain about tax," the old adage asserts, "can be divided into two groups: men and women." The view that paying taxes is to be avoided doesn't just entail a potentially uncomfortable brush with the taxman.

'People who complain about tax," the old adage asserts, "can be divided into two groups: men and women." The view that paying taxes is to be avoided doesn't just entail a potentially uncomfortable brush with the taxman.

It can also corrupt your investment decision-making in a most expensive manner.

If you've thought, "I won't sell now as I'll have to pay capital gains tax", or "I should sell now to lock in my losses", or "this investment is attractive because of the tax deduction", then tax considerations, not the merits of an investment itself, are adversely affecting your portfolio's returns.

Never selling

Not selling an investment when you should because you don't want to pay capital gains tax is perhaps the most common trap. This behaviour is caused by "anchoring", a cognitive bias where we use irrelevant information - in this case tax - to make investment decisions.

The problem is that holding on to an investment to avoid a tax bill may well mean you end up owning an overpriced stock.

That exposes you to far more risk of significant loss because, over time, stock prices tend to reflect the underlying value of a business.

To avoid this pitfall, shift attention away from the price paid (and the tax due) to the difference between the price of a stock and the value at which it trades. Investors could even try removing any reference to the purchase price in your broking account and replace it with estimated value. That way they have a subtle reminder that price and value - rather than purchase price - should be key to investment decision making.

Selling too soon

The second trap relates to selling stocks that have fallen in value to create a tax write-off, the opposite of never selling to avoid capital gains tax - although the same thinking lies behind each.

An investor's decision to sell should be based on a judgment about price and value, not what tax might be saved.

A useful tip to avoid this trap is to record the reasons for the original investment, including a sell price, and whenever tempted to sell, review the reasons for making the original investment.

The average Australian's obsession with negatively geared (loss-making, at least in yield terms) residential property is evidence of this trait, encouraging people to invest in property that may yield less than a bank term deposit. The tax deductibility of interest payments encourages this type of thinking.

Investing in an asset through the lens of tax deductibility tends to warp one's thinking to the point where losses become an advantage (the bigger the losses, the greater the deduction). Again, one ends up focusing on the tax aspects of an investment rather than the price one pays for it. This was especially true of all those investors in managed investment schemes. Many ended up with savage losses.

The solution to avoiding these traps is to concentrate on the value of an investment, not the tax implications of buying or selling.

Ask yourself the following two questions: Would I still want to sell/hold if my tax rate was 0 per cent, and would I prefer to pay a tax bill and make a profit or pay no tax and make a loss?

By focusing on value and buying great businesses for less than they're worth, investors will more than make up for any short-term "benefit" received from tax trading.

Keep track of tax

Another trap to avoid is where tax trading starts to look appealing.

Investors often start "tax trading" to meet a pending tax bill.

Investors can avoid that by keeping a running record of their likely tax bill (use the calculator on the ATO website) and putting aside enough cash to cover it.

Finally, understand that paying tax is a natural consequence of making money. Successful investors don't let prospective tax bills stop them from making the best investment decision.

They understand short-term "tax trading" reduces their chance of long-term outperformance, which, ironically, is the aim of avoiding tax in the first place.

Becoming a successful investor entails buying underpriced companies and selling overpriced ones. It has nothing at all to do with the tax paid on the way through.

Apply the above techniques and investors should avoid some of the worst tax traps and enjoy better portfolio returns.

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