Investing is an important part of building long term wealth, but investment decisions can also have tax consequences. When you sell an investment, realize a significant gain, or transfer assets to family members, the timing and structure of those decisions can affect how much you ultimately keep.
A thoughtful tax strategy can help you understand those potential consequences before making a move. As we discuss in our article on Simple Tax Planning Strategies for Long Term Savings, tax planning does not always require a complicated strategy. Making informed decisions throughout the year can create meaningful benefits over time.
Here are several tax considerations to keep in mind when managing your investment portfolio.
Be Strategic About Which Shares You Sell
If you have purchased shares of the same investment at different times, those shares may have different cost bases. When you decide to sell, identifying which shares are sold can affect the amount of capital gain or loss you report.
For example, selling shares purchased at a higher price may result in a smaller taxable gain than selling shares purchased at a lower price.
When possible, work with your broker to identify the specific shares you want to sell rather than automatically relying on a default method. It is also important to maintain accurate records of your cost basis, particularly for older investments where complete information may not be reflected on Form 1099 B.
Consider the Timing of Large Investment Gains
A successful investment can create a significant tax obligation when it is eventually sold. If an investment has increased substantially in value, selling your entire position at once could result in a large capital gain in a single tax year.
Depending on your circumstances, spreading sales across multiple years may help manage the tax impact. Investment losses may also be available to offset certain gains, while donating appreciated investments to charity may provide another tax planning opportunity.
Timing can be particularly important as the end of the year approaches. Our article, Turn Your Q4 Into Tax Savings, discusses additional year end planning opportunities, including the potential tax advantages of donating appreciated stock rather than cash.
The important part is considering the tax impact before completing the transaction rather than waiting until tax preparation begins.
Understand the Net Investment Income Tax
For higher income taxpayers, a large investment gain may create an additional consideration: the 3.8% Net Investment Income Tax, commonly referred to as NIIT.
Because a significant investment sale can increase your income for the year, it may cause some investment income to become subject to this additional tax.
Before realizing a substantial gain, consider estimating your expected annual income and the potential tax impact of the transaction. When there is flexibility around timing, spreading sales across multiple years or realizing gains during a lower income year may provide additional planning opportunities.
Remember State Taxes
Federal capital gains taxes are only one part of the equation. Depending on where you live, investment gains may also be subject to state income taxes.
This becomes particularly important when considering a significant investment sale, an unusually large gain, or a move from one state to another.
If a move is part of a larger change in your personal or financial situation, our article on Life Changes That Could Change Your Tax Situation covers several situations where planning ahead can help you better understand the potential tax impact.
Understanding both the federal and state tax consequences can give you a more complete picture of what you will actually keep after taxes.
Consider Taxes When Transferring Wealth
Cost basis can also play an important role when deciding how and when to transfer assets to family members.
For example, appreciated investments given to someone during your lifetime generally retain your original cost basis. Inherited property, however, generally receives a basis adjustment based on its value at the owner’s death.
That difference can significantly affect the taxable gain associated with an asset.
Estate planning decisions involve more than taxes, and every situation is different. However, considering the cost basis and tax characteristics of different assets can help you make more informed decisions about which assets to gift during your lifetime and which to retain as part of your estate.
Investment decisions can also overlap with retirement planning. For additional considerations around managing the tax impact of retirement assets and distributions, read Tax Efficient Retirement Requires Planning.
Make Tax Planning Part of Your Investment Strategy
Investment decisions should not be driven by taxes alone, but understanding the tax implications before making a significant transaction can help you avoid surprises and identify opportunities.
Whether you are considering selling an appreciated investment, rebalancing your portfolio, realizing gains or losses, making charitable gifts, or transferring wealth to family members, proactive planning can make a meaningful difference.
If you are considering a significant investment transaction, contact Somich & Associates. Our team can help you understand the potential tax impact and identify planning opportunities based on your individual financial situation.