Investors are often faced with taking a potential capital gain on a highly appreciated stock, exchange-traded fund (ETF) or mutual fund investment when that investment begins to underperform and increases the risk in a taxable portfolio. This phenomenon can create conflicting emotions because many investors seek to minimize taxes or avoid them all together.
It's been easy to observe this recently because of the long bull market that appears to be entering its later stages. In addition, when companies like Facebook Inc. makes news headlines and their stock pulls back significantly, the first instinct is often to sell the investment to reduce your risk and exposure. However, the fact that a large tax bill will accompany this transaction can make an investor hesitate.
Here are some ways to reduce potential tax liabilities on investment gains. (For more, see: Capital Gains Tax 101.)
Tax Management Strategies
So how should an investor manage this issue? The good news is that paying capital gains tax means the investor has made money and that is ultimately the goal. In these situations, the tax treatment is typically long-term capital gains tax which is taxed at substantially lower rates than short-term capital gains.
A couple of ways to reduce the potential tax liability is to look for other positions to sell that may be at a loss, either long term or short term. Those losses will be netted against gains and reduce tax liability. Carry over losses may also be applied if the investor has them.
Other strategies are to donate the investment to a charity or donor-advised fund and take a charitable contribution to reduce taxation and eliminate the investment from one’s portfolio. The investor in this case does not have the asset for personal use or the proceeds from a sale to use, but they will get a tax deduction. The tax deduction will be for the fair market value of the stock.
The limitation on the amount of the deduction taken in the year donated will be 30% of adjusted gross income (AGI) for a public charity or 20% of AGI for a private charity. Any amount left over can be carried forward for five years.
Another strategy is setting up a capital gains budget. This can be done by selling enough shares that equal the amount of capital gains the investor is willing to absorb and/or an amount of capital gains that won’t push the investor into the next higher tax bracket. Be careful to also consider the 3.8% Medicare surtax triggers at the higher income tax bracket levels.
Lastly, a staggered or staged selling strategy may be used. This is where the investor agrees to sell at certain predetermined prices with a commitment to do so ahead of time regardless of market conditions. This is a more disciplined approach that requires the investor to understand that future growth in the investment can be lost in order to reduce potential tax burdens and further diversify the portfolio to reduce risk.
The Bottom Line
Investors who have made significant gains in an investment should choose a strategy that suits their portfolio to mitigate capital gains taxes. (For more from this author, see: The Tax Consequences of Having Multiple Managers.)