While we are in the midst of tax season, capital gains taxes may be front and center when you get the good news or bad news from your accountant or your tax software program. No one likes paying taxes of any sort, but capital gains taxes can seem particularly vexing because they can vary from year to year and, unlike wages or social security payments, taxes are not automatically withheld. Calculating the federal capital gains rate is complicated because it is based on the amount of income from other sources you have within various tax brackets. State capital gains rates further add to the complexity.
In theory we have more control over when and how much we pay in capital gains taxes. There are strategies to minimize the amount of capital gains due, for example, by selling securities that have long-term losses in the same year in which trades with gains are taken.
There are occasions where investors have no control over the distribution of capital gains. Some mergers or acquisitions may consist of either a mix of stock in the successor entity plus some cash or an all cash transaction. In that case, unplanned capital gains are generated for all owners of the acquired company. Mutual funds, even index funds, may make capital gain distributions.
Assuming there are no losses to be harvested, there is the idea of avoiding capital gains altogether by never selling securities which have appreciated in value. This is letting the tax tail wag the dog. It bolsters our reluctance to trim winning stocks or funds lest we lose out on further gains. For example, shares in company ABC went up by about ninety per cent last year. Did we intend to have a position in ABC that was twice as large at the end of the year? Has our overall exposure to equities, both domestic and international, increased beyond our target level? If we are letting the tax tail wag the dog, we may ignore or at least minimize the risk to our portfolio in our effort to avoid paying taxes. Equities are considered the riskiest asset class in terms of volatility of overall returns. That risk is exacerbated when one or two large positions eclipse the other holdings in a portfolio.
Many investors are pleasantly surprised when some or all their capital gains are taxed at the ten or fifteen percent federal rate rather than the maximum twenty percent rate. Even at the maximum rate it is worth considering that a one dollar decline in the gain on an appreciated asset results in a twenty cent loss for Uncle Sam and an eighty cent decline for the investor.
Ben Franklin said, “nothing can be certain but death and taxes.” At Bigelow Investment Advisors, we cannot change the immutable facts described by Mr. Franklin. We can, however, work with your accountant and other professionals to understand the impact of taxes on your portfolio and other financial matters in a holistic fashion.