People who do the majority, if not all, of their investing in retirement accounts have a relatively easy task when making ongoing investment decisions. Assets in 401k and traditional IRAs aren’t taxed until they're withdrawn, so investors don’t need to think about the tax consequences of each transaction.
Investors in non-retirement brokerage accounts must think differently each time they decide to sell a position. They must consider capital gains taxes and weigh the cost of making a change compared to the benefits.
Given the strong performance of stock markets over the past several years, many people own investments that have large built-in capital gains with taxes due when that stock or fund is sold. The long-term capital gains tax rate – 15 percent for most people but as high as 23.8 percent – is less than the ordinary income tax rate for many people. However, most people have a general aversion to paying taxes at any rate.
If you’ve held, Boeing, Amazon, Starbucks or many other stocks that have posted gains in the hundreds and even 1,000-plus percent territory over the past several years, you’re certainly thankful for the performance, but it creates a bit of a predicament.
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Stocks that grow swiftly can become more concentrated positions in your portfolio than originally intended.
You might start out with a stock that makes up 4 percent of your holdings. If it does very well, its weight in your portfolio could climb significantly. The more concentrated your holdings get in any one, two or a few positions, the more risk you take that during an eventual downturn, these positions will worsen your portfolio’s performance compared to one with broader diversification.
Of course, you might be comfortable with some decline because it's unlikely to erase all the previous gains. But investing is a psychological endeavor and regardless of what came before it, a decline won’t feel good. You’ll likely feel better having captured some gain while it was there.
As stock markets have returned to choppier trading over the past two months, more people are thinking about capturing gains and rebalancing investments. For those who hesitate because of the tax cost, here are some possibilities to think about when weighing changes to your investments:
▪ In non-retirement accounts, at your death, holdings receive what is called a step-up in cost basis. This eliminates capital gains taxes when assets from this type of account pass to your heirs. A new capital gains meter starts running at the date of death value instead.
For elderly investors, it might be more beneficial to continue to hold positions with large gains if those gains will be eliminated by this basis step-up. Then, once transferred to the heir, the heir can sell and revise to fit his or her investment approach without paying much, or possibly any, capital gains tax.
▪ Some people who have had investments with large gains have built those positions with multiple purchases of shares over time. You might be able to identify which purchases have the lowest capital gain and sell only the shares with lower tax consequence.
▪ For the charitably inclined, two routes can make tax-friendly use of investments with large capital gains.
Rather than donating cash, gift shares of your appreciated investments. Or, if instead of making a pure donation you prefer to make a charitable gift that provides income back to you – such as a Charitable Gift Annuity or charitable trust – you can fund that donation vehicle with shares of investments also.
Donations are especially useful if you don’t know the cost basis of an investment. Gifting it eliminates the need to determine the basis because neither you nor the charitable organization will owe any tax.
Whatever considerations best suit your individual financial situation, don’t let taxation have a larger influence than necessary on your decisions. There can be benefits beyond the tax cost. There is nothing wrong with harvesting a gain. Either you will free up cash for needed expenses or you will have the opportunity to reposition the money to improve the diversity and balance of your investment mix.
Sure, you might sell early. Momentum may continue, generating even more gains. This is why you likely shouldn’t sell all of a position that has done very well. Trim it incrementally. You get the benefit of turning some of the gain from paper to realized and you continue to own shares that might capture future growth.
Just keep in mind that you can spend only your after-tax returns, so it helps to be tax-wise about investment decisions.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor. Reach him at firstname.lastname@example.org.