During a recent portfolio review with one of my clients, she asked me why she didn’t have to pay any taxes last year even though her portfolio had substantially increased in value. She said the income and gains reported on her tax return were minimal. She was expecting a large tax bill given the portfolio performance.
It’s important for clients to know that your tax bill doesn’t always mean your investment portfolio had a good year or a bad year. The total return on a portfolio is made up of income and capital gains/losses. Income is comprised of dividends paid on stocks as well as interest paid on bonds. Outside of a retirement account (IRA, 401k), income is taxable in the year it is received.
Capital gains are defined as the amount of gain in the price of an investment over the purchase price. If the price is lower than your purchase price, it’s a capital loss. If you purchase a stock at $40 and it goes up to $50, you have an (unrealized) capital gain of $10. It is not taxable until the stock is sold (realized). Capital gains/losses show up on your tax return for taxable accounts when they are realized, and losses can offset gains minimizing any tax owed. It is possible to have the majority of your investments appreciate substantially in one year, but if you don’t sell any of them you wouldn’t incur any tax. Or if you sell one stock in your portfolio at a loss, when the rest of the stocks that you hold have substantial gains, then you could owe nothing in taxes but your portfolio value is substantially higher.
If the investments are held in a retirement account (IRA, 401k), neither income nor capital gains are taxed. Only money withdrawn from a retirement account is taxed.
My client’s portfolio had done very well in 2012; however, we had done some tax loss selling to offset some capital gains in her portfolio so she would not have to pay a lot in taxes. The tax forms she received reported little net gains and interest for the year.
We aim to manage our portfolios in the most tax-efficient manner we can for our clients. Taxes have changed over the years, and they will likely continue to do so. Your tax bill, or lack of, is not necessarily reflective of how your portfolio performed for the year.
Please call or email with any questions or concerns regarding how we manage our client’s portfolios to minimize taxes, or how your portfolio is performing.
Marisa A. Lenhard, CFA, CFP®