One of the many facets of investment management is the consideration of tax consequences. This can be as high-level as taking a distribution from a Roth IRA rather than a Traditional IRA, and as granular as timing the sale date of a security to ensure its appreciation is a long-term capital gain rather than a short-term gain. This blog is the first of a three-part series addressing tax considerations within a portfolio, starting with the concept of capital gains on investments.
The phrase “there’s no such thing as a free lunch” undoubtedly rings true in the investment world, where the government ensures it gets its share of investor capital gains. Simply put, the term “capital gain” refers to the money made on an investment (and conversely, a “capital loss” is the market value an investment lost). The IRS doesn’t count gains and losses on an investor’s tax return until they’re “realized” or converted into cash. If an investor buys a stock that only increases in price and holds it for three years before selling, they won’t pay any taxes on the profit until the third year, when the gain is realized.
Additionally, the length of time an investment is held affects the rate that it will be taxed. A “short-term capital gain” is defined as the profit made after the purchase and sale of a security within a calendar year. These gains are taxed at the investor’s marginal tax rate, which is determined by his regular income. However, a “long-term capital gain” is treated more favorably by the IRS and is taxed at the 20% tax rate regardless of the investor’s income level. As income increases (along with marginal tax rate), it’s easy to see why many clients prefer a long-term capital gain over a short-term capital gain.
An astute financial advisor understands these concepts and is mindful of their client’s overall tax situation. While capital gains and losses are just a small tile in the mosaic, they can be used in conjunction with other strategies to create more advantageous situations for clients. For example, perhaps a client in a high marginal tax bracket needs his advisor to sell some mutual funds to generate cash for a down payment on a property. In this situation, one way to help minimize tax consequence would be to sell funds that have been held for longer than one year so that they’re taxed as long-term gains rather than selling funds that would trigger a short-term gain. This allows the investor to keep more of their gain from the investment.
Next time, we’ll look at various elements of portfolio taxation with a focus on the types of accounts and their taxable statuses.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.