Dear Mr. Market:

Not only do you toy with the emotions of every investor; you also have a partner that often surprises them and hits investors where it hurts the most… their pocketbook. Making money in the stock market is great but so many forget that eventually they have to reconcile with Uncle Sam come tax time. Look for example at some investments that we have recently discussed: Under Armour (UA) and InvenSense (INVN).   If you had purchased these stocks on the first trading day of this year (1/2/2014) you would be up 58% with Under Armour and up 20% with InvenSense. These numbers are impressive and would certainly make any investor happy but what happens when they are sold? How will they impact your tax return and how much of the gain will you have to pay?

“Nothing is certain except death and taxes.”

                            – Benjamin Franklin 

*** Before we move any further in this discussion it is important to note that we are not tax advisors. In this article we will be discussing general guidelines. Every investor’s situation is unique and deserves personal attention. If you have questions we would encourage you to talk with a qualified tax professional.

Let’s take a moment to go over some of the basics when it comes to investor tax issues.

Capital Gains: When you sell an investment for a profit you will be taxed. If the investment is held for less than a year you will pay your ordinary tax rate (up to 35%). If the investment is held for longer than one year you will pay a lower rate of 15% (high-rate tax payers will pay more). There are other investments that carry different tax ramifications with them such as: collectibles, futures contracts, options and real estate. Individuals in the two lowest tax brackets will be assessed a 5% rate on long-term gains.

For example: Let’s assume an investor is in the 25% tax bracket and they sell 500 shares of ABC stock at $75 when it was purchased at $50. They would have realized a gain of $12, 500. If the position was owned for over one year they would owe $1,875 (15% of (75-50) x 500). If the position was owned for less than a year they would owe $3,125.

Dividends: It is important to remember that companies pay dividends from after-tax profits, which essentially means that Uncle Sam has already taken his share. If the company is located in the U.S., shareholders pay a tax rate of 15% – these are called “qualified dividends”. If the dividend is received from a foreign company or are classified as “non-qualified” they are taxed at the investors regular tax rate.

Interest: Interest is taxed as ordinary income and will be subject to the marginal tax rate the investor pays. The exception is Municipal Bonds – these can be exempt of federal and state taxes. Often you will hear the phrase “double tax free” when looking at municipal bonds. Investors should not assume that municipal bonds are tax-free; they should inquire and confirm that this is the case. Municipal bond investors need to reside in the state the bond is issued from to qualify for the state tax exemption.

Tax Losses: Let’s face it… not all investments go up and in many cases positions are sold at a loss. The silver lining here is that these losses can be used to offset capital gains realized either in the same tax period or carried forward from previous years.   Investors can deduct up to $3,000 of losses against income each year and any excess losses can be used in future years.

Each year investors should examine their portfolio to see if they can benefit from “Tax Loss Harvesting”.   If investors have gains they can offset these by selling other investments that are below their initial purchase price. One key factor to keep in mind when selling positions is to be aware of the “wash sale” rule. If a substantially identical position is purchased within 30 days the IRS can disallow the capital loss.

Now that we have established the basics of ‘Investments and Taxes’ where do we go from here?

Investors are often paralyzed when it comes to the tax ramifications associated with the investments in their portfolio. It can go either way –Have you ever not wanted to sell a position that is down thinking it will come back? Conversely, why sell a position that is up? More often than not this leads to investors doing nothing with their portfolio, which is really doing something! If taxes are a concern here are some items to keep in mind:

• Sell higher cost basis shares – if you have multiple purchases in a stock and are looking to cut back on your exposure, sell the higher priced shares first.
• If you own mutual funds avoid buying ones that have a high ‘turnover ratio’ associated with them. This number indicates the percentage of the portfolio that is traded on a yearly basis. Many investors don’t realize that although they are long-term holders of the fund there are hundreds of transactions taking place within the fund that carry tax consequences and they have no control over them.
• Consider the timing of your sales – in a picture perfect scenario (which rarely happens) you would offset all your gains plus an additional $3k to offset your regular earned income.   Be aware if you are near the one-year holding period when selling a security.
• Purchase individual stocks in your IRA or qualified accounts as this will make most tax issues a non-issue. Consider being more conservative in your taxable accounts.

Obviously every investor and portfolio is unique and their tax situation will present different challenges. There truly isn’t a ‘one size fits all’ approach when it comes to investments and taxes. While taxes are important and a topic that nobody likes to discuss, let’s take a step back and look at why people invest. If people wanted their money to stay stagnant and simply stay at the same value for years down the road they would simply deposit it in the bank or hide it under a mattress. People invest so that their money will grow and help them reach their goals at a faster pace. Taxes are important to consider but they shouldn’t be the driving force when managing a portfolio.

“Don’t let the tax tail wag the investment dog”

Far too often we have seen investors ride an investment up and then ride it right back down as they either think it will continue to go up or they fear paying the taxes. We would suggest that if you struggle with this that you consider trying to phase yourself out of investments that have done well. If you have a substantial gain in a position and don’t know how to handle it, think about selling a portion of the stock; it doesn’t have to be all in or all out. Also keep in mind that if you have a gain in a stock to keep a portion of the proceeds to pay the tax liability when you settle up with Uncle Sam. Investors buy stocks for growth – don’t allow that growth to only be on paper, because at some point you need to make it a reality!

Something to consider….

You’ve done your best to adhere to the typical “buy and hold” advice. You’ve held on to solid blue-chip stocks and even some others that have done really well for you over the past five years. By the way…what has NOT done well lately? One of our favorite sayings is that “in a rising tide all of the boats rise”.

That being said, you know the market is very near a breaking point and things could change quickly. Your memory is cloudy but you can recall these same stocks getting crushed in 2008…or perhaps even back in 2002. Still…if you sell now you will pay big gains and after all…these stocks all came back anyway, right? Yes…they sure did, but in reality you did yourself no favors by not taking advantage of some of the past peaks. In essence all that you did was ride them up, then down, and back up again. We’re now close to the top of the roller coaster and you are likely committing yourself to a pair of “tax handcuffs” all because you don’t want to pay long-term gains.

Think about it: Is it better to pay 15% long-term taxes or ride it down 20% to possibly 30% and have to wait a few years to be right back at square one? Wouldn’t it be prudent to make a few calculated sales now and reallocate the proceeds rather than repeat the useless roller coaster ride?

If you find this overwhelming and you’re paralyzed by all these moving pieces it might be time to seek help. We would encourage you to find a fee based financial advisor that can help you manage through the process. Avoid working with a commission-based advisor, as they will be licking their chops looking all the commissions they will generate and line their pockets with. We offer every prospective client a complimentary portfolio analysis with specific recommendations. Please contact us with the form below or you contact us at: (888) 47- GUIDE or (888) 474-8433.