1/23/2014 11:30 PM ET|
Is your portfolio a tax time-bomb?
Last year's incredible returns could be this year's tax problem. Here are some strategies to minimize the tax impact of those big gains.
2013 was a great year for equity investors, but as you count your gains, remember that last year's prosperity can be this year's tax problem. All those gains may have turned your portfolio into a ticking tax time-bomb.
The S&P 500 ($INX) rose more than 30 percent in 2013. Any U.S. stock portfolio should be looking much fatter as a result, but keep in mind that if your portfolio is taxable, you will have to give some of that increase back in the form of realized gains taxes. What's more to the point, the real tax liability may be waiting to hit you in the 2014 tax year.
The dangers of unrealized gains
While you may have racked up around 30 percent worth of paper gains in 2013, unless your portfolio is managed in a high-turnover approach, chances are that much of that increase is in the form of unrealized gains – meaning you haven't cashed in those shares yet.
If you have not done so already, you should tally up your realized gains from last year, just so you will have a feel for what kind of tax bill you will be looking at this April.
More importantly for planning purposes, you should also look at the magnitude of unrealized gains in your portfolio. Since investment gains are only taxed when you sell a security, the large unrealized gains that can build up when a portfolio has a strong year can become a problem in future years.
For example, your portfolio might only break even in 2014, but if you sell any stocks that were up big in 2013, you may face a tax liability for this year that exceeds your investment return.
How can you defuse this ticking time-bomb? The truth is, you cannot expect gains without paying some taxes, but there are ways you can manage the impact of a large build-up in unrealized gains. Here are five suggestions:
- Don't count your chickens. When revaluing your portfolio for planning purposes, you may want to discount the market value by the amount of any large, unrealized tax liability.
- Build up a tax reserve against unrealized gains. This is to make sure your cash flow can handle the future tax liability.
- Avoid timing traps. Make sure you don't sell just as a stock is about to go long-term or a calendar year is about to end.
- Audit your portfolio for weak links. You shouldn't sell stocks just because they are down, but if a stock is down and its business prospects have diminished, getting the tax benefit of realizing the loss can take some of the sting out of a failed investment.
- Consider substitutions as another way of realizing losses to offset gains. Wash-sale rules prevent you from re-purchasing a stock on which you are claiming a loss for 30 days, but if you own a group of stocks purely to capture that sector, you may be able to find a group of suitable substitutes or a sector-based ETF you can buy immediately so you can realize losses on the original group.
Always remember, taxes on gains are a sign of a healthy portfolio. In other words, it's a good problem to have.
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Correct me if I am wrong on any of this. This is just what I figured out on my own.
While your money is in IRA and/or a 401k it can accumulate tax free, but you have to pay taxes on every penny you draw out. Your broker can withhold estimated state and federal taxes when you make withdrawals.
401k/IRA money withdrawn is taxed on your income tax after being added to your Social Security or other pensions and dividends, pushing it into a higher bracket.
To stay out of a higher bracket, figure out how much you can withdraw and stay in the 20% bracket after adding it onto your other income..
We need to know more about how inherited 401k/IRAs work for our heirs. Most heirs need the money now, not for retirement. It would pay to get a good tax man's advice. Most inheritances are tax free, but are 401k and IRA inheritances tax free? Someone told me that the one who inherits doesn't have to pay taxes, but they will tax the IRA or 401k of the deceased person who has left the retirement money.
There are potholes, like when you turn 70 some you have to start cashing out. (I am not sure of the exact age). Being forced to sell can catch you in a down market. If you don't start cashing out at the right time and withdraw the right amount, you can lose it to the government in higher taxes and fees for late withdrawal.
You or your heirs will pay a lot higher tax rate, if you take it all out at once. Even if each heir takes a low amount, added together it can cause higher taxes.
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