With April 15 less than a month away, chances are that you have recently reviewed all of the things you do in your life that cause you to pay taxes. There are lots of articles being written right now about how the new tax law has surprised taxpayers in both the amount that they will pay and in what is creating their taxes.
Another surprise for some taxpayers this year was the amount of capital gains they had in their portfolios, and the tax that was created by it. As financial advisors, we consider the effect that taxes will have on the actual returns our clients will realize. That is why we encourage our clients to use investments that will defer taxes such as 401(k) plans, traditional IRAs, and annuities, or to use plans that allow your money to grow tax-free, such as Roth IRAs and 529 Plans. However, each of these types of plans has a trade-off. For example, a 529 Plan does allow your money to grow tax-free, but it must be used for education, or there is a penalty for withdrawal. Your 401(k) plan may be a great program for you to make scheduled tax deductible contributions that will grow tax deferred, but most withdrawals for people under the age of 59½ will have a 10% penalty.
If you are an investor that wants to accumulate funds that you have access to at any time for any reason, you might then invest in a brokerage or mutual fund account. Many times we recommend this type of account when designing a financial plan so that our clients have a secondary reserve in addition to their emergency funds. These accounts may serve as an accumulation tool for a life goal, or as another investment option once they have funded all of their tax-advantaged plans. As these assets grow over time, taxes become more and more of a focus as we analyze our clients’ net return.
Capital gains are created in two ways. The first way is when the value of something you own goes up, and you sell it, creating a gain that you need to pay tax on. For example, you buy Stock A at $20 per share and sell it at $25 per share, so you realized a gain of $5 on the stock and are required to pay taxes on it.
Capital gains are also passed on to investors when they are declared by mutual funds. Mutual funds are required to distribute nearly all profits to its shareholders, so that means that if Mutual Fund XYZ bought Stock A at $20 per share and sells it at $25 per share, that gain will be passed on to the investors who own shares of Mutual Fund XYZ. The investors will receive a Form 1099 detailing the taxable gain, and will pay taxes depending on their tax bracket.
In recent years we have seen a higher level of capital gains declared, mostly due to the advance in the stock market. As funds make money, they are required to pass both the gains and the taxes to you. The fact that significant gains were declared in 2018, a year that may not have provided much increase in the account value for investors, is a reminder that investors need to consider gains every year.
What can you do to be prepared in future years? Here are my top four tips:
Talk to your financial advisor. One of our primary focuses in the fourth quarter each year is analyzing our clients’ portfolios that are exposed to taxes and making recommendations to hold or sell assets, based on what we know about potential capital gains and our clients’ goals. For some clients we recommend that they avoid the gain, and for others we recommend that they realize the gain, depending on all of the details we know about their other expected taxes in the current year and in future years. Without all of those details, we may not be able to make the best recommendation to hold or to sell.
Consider tax loss harvesting. If you do have capital gains, you can offset those gains with capital losses from a previous year, or from a different investment. Let’s say you bought Stock B for $50 per share, and it is now worth $40 per share. If you sell Stock B, you can use your $10 loss per share to offset the gain in Stock A.
Consider your holding period. If you hold the asset for less than one year, your gain will be taxed at your ordinary income tax rate. If you hold it for longer than a year, the gain will be taxed at the capital gain rate, which may be lower. See the IRS site for details: https://www.irs.gov/taxtopics/tc409
Talk to your tax professional. Just as your portfolio design should be unique to you and your goals, your tax return is unique to you and your sources of income and gains. There are myriad factors that will determine your final tax due - such as tax losses and your holding period - and your tax professional should know how they affect your tax return.
Our goal is to help people to use their money to have the lives they want. We know that when you understand how to make a financial decision, you can be more confident about those decisions. If you’d like to learn more about how we design financial plans for our clients, please visit us at debrabrennantagg.com, firstname.lastname@example.org, or (972) 980-7526.
Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. This material is intended for informational purposes only and should not be construed or acted upon as individualized tax, legal or investment advice. Federal tax laws are complex and subject to change. Neither FSC Securities Corporation, nor its registered representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.