One of the things that our clients really desire is to have a better understanding of taxes and how they work. Our role is to serve as a guide for our clients through all the complex financial decisions that they make during their lifetime so that they can worry less about money and focus on what is truly important, loving relationships, meaningful work, and memorable experiences.
We often hear a lot about capital gains with respect to taxes. What are they and how are they taxed? For me, my years of teaching on Aberdeen Proving Grounds in the chemical weapons disposal program, I had to first learn complex processes then describe them to engineers and technicians who had no familiarity with the subject. What I found is that I needed to simplify the subjects first in my mind and then find things we all know to explain the subject. Paraphrasing Einstein, you really do not understand a subject unless you can explain it to a 5 year old. Often at church, I better understand the pastor’s message when I listened to the children’s sermon then the regular sermon. I digress.
What are capital gains? Simply put, you buy something for one price and you sell it for something more and the difference is your capital gain. We all are encouraged to buy low and sell high. A capital gain is when we buy stock, real estate, or other investment and it appreciates to a higher value. Pretty simple, eh!! Don’t let the tax jargon confuse you. It is just learning a new language. Now, if we buy something and the price goes down, we have a capital loss. Good so far?
For many of us, a lot of our liquid net worth is investing through mutual funds, index funds, and exchange traded funds. There are two aspects of capital gains that we need to understand. The first is that mutual funds are typically made of multiple stocks or bonds that provide diversification. A typical stock mutual fund may have anywhere from 30 stocks to thousands just in one fund.
The first capital gain is when the manager of the fund buys and sells stocks within the fund. For instance, if the manager buys Tesla stock for a given price and then they sell it, they will have a capital gain or loss. At year end , if you have a non-retirement or post-tax account, you will receive a 1099 tax form that reports these capital gains. A key thing is that the capital gain is not recognized until the sale is made. You may hear about realized and unrealized gains. Realized is when the stock is sold and now is taxable event, where as, unrealized means that the stock has yet to be sold and at some point may become a taxable event.
The second component of capital gain that you might experience is the actual appreciation that you yourself have experienced by owning the fund. If someone bought the S&P 500 index fund in a non-retirement account. They invest $500,000 into it and it appreciated to $600,000. At this point, they have $100,000 of unrealized gains because they have not yet sold the holding. The point at which they sells shares, they will have realized gains that will be a reportable taxable event.
In summary, capital gains within mutual funds have two components: (1) The capital gains realized by the manager when they buy and sell the individual stocks and bonds within the fund and (2) When you the investor buy and sell shares of the fund itself.
Now, how are they taxed. For those who we meet with regularly, we show a lot of our tax management graphics. We show graphic of three funnels on how investments are taxed. The three funnels are pre-tax, post-tax, and tax advantaged.
Pre-tax accounts are your retirement accounts like 401k, 403b, IRA, and TSP. Key thing to remember about pre-tax accounts, you do not pay taxes on capital gains. Any buying or selling within the account does not trigger any kind of capital gains taxes either by the fund manager or you yourself. You only pay tax whenever you withdraw money out of the account at ordinary income rates.
Tax advantaged accounts like Roth IRA’s are similar to pre-tax accounts with respect to capital gains in that one does not pay taxes on capital gains. Key difference is that as long as you are 59 1/2 and had Roth for longer than 5 years, whenever you withdraw money out of Roth, it is tax free.
Finally, is the post-tax accounts. This is money in which you have already paid tax on when you make the initial investment. This is where you pay tax at capital gains rates. For mutual funds, you are paying the capital gains recognized by the manager by them selling the individual stocks and bonds within the fund. This is a tax you will likely have annually. Then for not only mutual funds but real estate, individual stocks and bonds, and other investments, when you actually sell the investment, if you have appreciation at that point you will have realized gain that becomes taxable.
I hope this gives you a better understanding of capital gains as you take your tax management journey. If you have questions, concerns, or want clarification, please contact your financial professional at Harford Financial Group or contact Melissa Busler at firstname.lastname@example.org or 410-838-2992 and she will put you in contact with us. Remember, our mission is to help you live a life of meaning and purpose. Having good control of our financial life allows us to focus on what is essential.