Capital Gains Taxes: I’m Sorry and You’re Welcome
I’m Sorry…
As markets continue to rise, many investors are enjoying the ride as their portfolios grow. The gains are welcome news. But as much as we might like gains, they can also present challenges. Speaking here directly to my clients, you are welcome and I am sorry.
What I’m sorry for is capital gains taxes. It’s a rare person who likes to pay taxes. Most people loathe them. Capital gains taxes can be particularly annoying because they can present as a nasty surprise during tax season. Unlike income-related taxes, you don’t normally withhold for capital gains taxes. As a result, they can resurface during tax season, sometimes long after the taxpayer has forgotten about the original transaction. Unwelcome news indeed.
So Just What are Capital Gains Taxes Anyway?
They occur in a taxable account, not a retirement account like a 401k or IRA. If we sell something that has gained in value, you the account owner owes tax on the amount of the net gain. For example, say we invested $10,000 into something that grew 100% to $20,000. Pretty good right? Then if you sold that investment you would realize the gain. You would owe capital gains taxes on the $10,000 made on that investment. Depending on your income, the tax could be 15% or $1,500. The net gain after taxes would be $8,500. This is a super simplified example and leaves out important details that we will set aside for this discussion[i].
Since this activity can happen throughout the year, it could be months between the sale that triggers the capital gain and April 15 of the next year when the tax is due. If overall your account gained during the year, you probably feel okay about the whole thing. But sometimes your account could be lower at the end of the year and you owe a capital gains tax. That situation can lead to some fun conversations.
You’re Welcome
So is this a good or a bad thing? Usually it is good. Capital gains taxes only happen because you made money on your investments. That’s why you’re investing in the first place. If you had no growth, or only losses, you’d have no capital gains taxes… but of course that wouldn’t be good at all, right?
As investors, we look to grow our portfolios over time, while managing risk along the way. In building portfolios, we closely consider potential durability: is the portfolio at risk of falling quickly if market conditions change? Or does it have resilience because it is made up of a balance of investments intended to weather a variety of conditions? An overly risky portfolio might do very well when times are good; but it might crumble when times change.
Periodic rebalancing is a process we use to build portfolio durability. The idea is to take some of the gains generated in growing categories after they start to look a bit stretched and then move those proceeds into areas that might offer better values or more protection should times get rocky. The intention is to moderate volatility and build resilience.
Think of it this way: say you have an account with a balance of $1MM. If a year’s worth of rebalancing delivered $25,000 in capital gains taxes, you might think wow that is an expensive hit. It’s 2.5% of the total account balance. But what if the rebalancing reduced potential losses? A $1MM account that is too risky could easily drop way more than 2.5% right? Is it better to reduce the risk of greater losses? We think so.
Can we Avoid Capital Gains?
The only ways to avoid capital gains taxes completely would be to have no gains, have a lot of losses, or to never sell. If you want your portfolio to grow and if you want to try to manage downside risk, you’ll eventually face capital gains taxes.
We can employ various strategies to minimize the impact. For example, we can sometimes apply losses against gains to minimize the amount of taxable exposure. This works great, unless there are no losses. Also, we could use cash generated within the account: instead of automatically reinvesting dividends we could let cash accumulate and then use it to rebalance. Or you could never sell. This might make sense in theory, but for some categories such as gold during 2025 or our emerging markets fund over the past twelve months, it sure seems to make sense to peel off some gains as the investment spikes into unusually high levels.
Conclusion
In spite of some short-term setbacks, markets have been strong in recent years. This means portfolios are growing and that makes investors happy. But it also means that there are precious few if any losses in accounts. As a result, making adjustments can come with the cost of capital gains.
In booming markets, it can be tempting to defer rebalancing and let it all roll. But we should never forget that times can change and bear markets are a normal occurrence. When – not if – the next bear market comes, we want to have portfolios appropriately positioned.
For clients, we will do our best to use appropriate strategies to manage capital gains impact. And we hope we can do a good job of educating you and setting expectations about what you might be facing. The tradeoff between appropriate allocation and costs like taxes is something we will work through, together.
Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.
This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services (Source: U.S. Department of Labor).
The PCE price index, or Personal Consumption Expenditures price index, is a measure of the prices of goods and services purchased by people in the United States.
[i] This is a simplified example provided for illustrative purposes. It does not include factors such as long-term versus short-term gains, Net Investment Income Tax (NIIT) for high earners, different brackets for different income earners, state-level capital gains taxes, or deductions for residential real estate transactions, etc. For specific tax implications for your own situation, please consult your tax professional.