While paying taxes is generally a good sign that you are making money, it seems most people want to avoid paying more tax than they need to. It’s a common enough question we field, and one worth considering.
How do we handle the tax impacts of our choices?
For smaller investors with tax-deferred vehicles like IRAs or 401(k) plans, tax considerations are simpler. Only deposits and withdrawals have any tax implications (and for Roth IRAs, rarely even then.)
Things get more complicated for investors with substantial balances outside of retirement accounts: most trading activity has tax impacts. You pay taxes on interest and dividend payments; you also become subject to capital gains tax when selling investments.
The principle of capital gains is straightforward enough. For instance, if you buy stock for $100 and later sell it for $100, you made no money and owe no tax. If you were to sell it for $110, you would have to pay some percentage of the $10 profit in tax (but not the rest of the $100: that was money you had in the first place.) And if you sold it at $90, you would have a loss of $10 that you could use to offset taxable gains elsewhere.
The important thing here is that the IRS generally only cares about the value of investments when they are bought or sold. If your $100 stock position balloons up to $1,000 one year and then collapses back down to $100 the next, the IRS has no interest in the round trip. They only see the difference from your original purchase, regardless of how high or low the price got in the meantime.
It is easy to despair when an investment is underperforming, but according to the IRS, those losses do not exist until you decide to sell. And if a high-flying investment should pull back from its highs, the IRS would give you a very funny look if you tried to claim it as a loss.
So if the IRS does not care about your gains or losses “on paper,” why should you? A drop is not a loss, and value at inception is a great anchor to come back to when you need a jolt of perspective.
And if after all this you find yourself with more resources than you would need in your lifetime, there are estate planning opportunities to consider. If you are sitting on long-term investment gains that you do not think you will be spending, there is little reason for you to sell those holdings and pay taxes on your gains yourself.
If those assets are passed down to your heirs, however, they would generally only need to worry about gains made after they inherited them, so whatever gains you accumulated during your lifetime can pass to them tax-free.
Lots to think about! It’s an important topic for many investors. Clients, when you need to talk about your tax considerations, please reach out.
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.
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