Few can be pleased with the stock market's performance over the last year or so. However, the market's recent rebound has raised the question of whether now is the time to capitalize on some of those newly realized gains on stocks purchased during the downturn. While taxes should not be the main factor in this decision, they should be considered, given that taxes can significantly impact the investment return.
Below are two simple, yet effective, strategies to consider as investment decisions are made on how to manage recent gains.
Timing The Sale Is Critical Capital assets such as stock, bonds and mutual funds, must be held more than 12 months to be taxed at the lower and more favorable long term capital gain rates (LTCG). The holding period for capital assets (e.g., stock, bonds and mutual funds, etc.) generally begins on the day after the purchase date and ends on (and includes) the day of disposition. For securities traded on an established securities market, the holding period is measured from trade date to trade date (the date when executed). The settlement date (the date when actually delivered) has no impact on the holding period. The gain or loss must be reported in the tax year in which the disposition (i.e., trade date) falls.
Of course, the decision to hold an asset should not be driven solely by tax consequences. However, one should be aware of the rules, since missing the required holding period by even one day results in a short-term capital gain, taxed at unfavorable and likely increasing, ordinary income rates.
If the sale qualifies for LTCG treatment, it will be taxed at a maximum federal tax rate of 15 percent and in some cases not taxed at all. Otherwise, it will be taxed at ordinary income tax rates, which can be as high as 35 percent under present law. Therefore, the tax obligation will be less and more gain preserved if the stock sale qualifies for LTCG treatment. The overall tax savings depends on the taxpayer's ordinary income tax bracket.
Evaluating The Investment Risk Of Deferring A Sale The question then becomes: Are the tax savings that would be realized by holding the security for the long-term period worth the investment risk that the security's value will fall during the same time period? If the value is expected to fall significantly or the market for the security is diminishing, liquidating quickly, regardless of tax consequences, may be the better option. Otherwise, the potential risk of holding the security should be weighed against the tax benefit of qualifying for the reduced LTCG tax rate.
For example, a...