Unrealized Gains and What They Mean for Your Taxes

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by Advice Chaser
by Advice Chaser
brown wooden trunk

Recently, a bombshell article by ProPublica revealed that many billionaires pay very little actual tax. Some reacted with rage at the unfairness of a system where the richest pay so much less of their money than the rest of us. Others find themselves asking, “How can I get in on this?”

Many of these billionaires’ tactics aren’t available to the rest of us, but one very influential strategy is unrealized gains. Your investments aren’t taxed until you sell them, meaning that keeping investments unrealized—or not converted into cash—can allow you a certain amount of tax-free growth.

What Are Unrealized Gains?

When you purchase a stock at $5, and it rises in price to $10, you’re theoretically $5 richer. But because the money is tied up in the stock, you don’t actually have your $5. Some call it a “paper profit.” Because you haven’t received any money, you don’t owe any taxes on your unrealized gain of $5.

Likewise, if you buy at $15 and the price goes down to $10, you’ve lost $5 on paper. For tax purposes, though, you’ve lost nothing and can’t write off the loss until you realize it—when you sell the stock.

This protects you from complex calculations of profit and loss while your stock fluctuates. All you need to know for your taxes is the price you bought the stock for and the price you sold it for. The purchase price is called the basis. The increase or decrease by the time you sell it is your profit or loss.

Stocks aren’t the only thing that can have unrealized gains or losses. Bonds, cryptocurrency, and real estate may also produce gains that stay unrealized until you sell them.

Tax Strategies

To minimize the tax you pay, plan the best time to realize your gains. That may include a year you are in a low tax bracket, a year you can offset your gains with equivalent losses, or a little at a time.

For instance, if you have to sell your home at a loss or you lose out on the stock market, it might be a good year to sell some investments at a profit as well. Adding up your losses and gains, you may have a total capital gain that’s low or negative, minimizing your capital gains tax liability.

If you have a large investment that will have to be sold at some point, consider ways to spread out the profits so they don’t all hit in a single year. That way, you won’t move into a high bracket in one year and lose such a large percentage of your profit. For instance, if you plan to sell your business to a successor, you can request payment in installments instead of in one lump sum.

Your financial advisor will have more ideas for spreading out the taxes you will owe for those unrealized gains.

Consider Your End Goal

Many tax planners consider the avoidance of tax an end goal. But what good is avoiding taxes if you can’t use your money? If your profit is all on paper, you can’t spend it. And of course, you can’t take your unrealized gains with you. Very few religions teach that it’s easier to get into the afterlife with a healthy portfolio.

Often, paying taxes is a reasonable tradeoff for realizing your gains and converting them into cash. This way, you can spend it on things you want, give it to your friends and family, or donate it to charity (for more tax benefits!). But there are a few cases in which it makes sense to keep gains unrealized and untaxed for a while.

Retirement

One time you may want to keep gains unrealized is when saving for retirement. You will need that money to live on in your golden years, and you don’t want to lose too much of it to taxes. Luckily, the government does allow for tax-advantaged savings.

When you save for retirement in a traditional 401(k) or IRA, all your gains remain unrealized until retirement. That means you pay no tax now, but you will when you withdraw the money. Conversely, when you save in a Roth 401(k) or IRA, you pay tax on your contributions, but you pay nothing when you withdraw the money during your retirement. That means you pay nothing on the gains!

Which option will save you the most in taxes? It depends on your situation. If you are in a high tax bracket now but expect to be in a lower one during your retirement, a traditional retirement account will minimize your tax liability. However, if you expect your tax bracket to remain steady or rise, a Roth account may make more sense.

A Legacy for Your Family

Unrealized gains have to be sold sooner or later, which means you will eventually pay taxes on them. One exception is inheritance. When you die, the basis, or assumed value, of your investments is stepped up to their fair market value at the time. That means your heirs won’t have to pay tax on the gains either.

Say you had a stock worth $10. Over the years you hold it, it increases in value to $100, and then you die. Instead of having to pay tax on the $90 gain, your heirs instead have a $100 stock just as they would if they had bought it for $100. Only if it rises further in price before they sell it do they have to pay tax on those gains.

Of course, they still have to pay estate tax on their inheritance. Consider ahead of time the amount you would like to leave to your children, while keeping their tax liability in mind.

Get Help With Your Unrealized Gains

Unrealized gains can feel like a time bomb hanging over your head. Sooner or later, you will have to sell those investments to use the money, and then you will have to pay tax on it. Some political experts are also warning that the unrealized gains loophole may eventually be closed. Plan for how you’ll handle those gains ahead of time by speaking with a skilled financial advisor. We can connect you with someone who realizes taxes are only part of the overall picture. Get started today!

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