When should I take the tax hit on unrealized gains?

Many clients often ask, “When is the best time to take the tax hit on unrealized gains?” The answer is unique to each situation and depends on various factors surrounding your decision to exit a position. While it’s important to understand the tax consequences of your actions, taxes should not be the only consideration. As the saying goes, don’t let the tax tail wag the investment dog.

Long-Term vs. Short-Term Gains

One of the key factors to consider is how long you’ve held the investment. Long-term capital gains—those on investments held for more than a year—are taxed at favorable rates, typically ranging from 0% to 20%, depending on your overall income. On the other hand, if you’ve held the investment for less than a year, any gains will be taxed as short-term capital gains, which are subject to your ordinary income tax rate.

While holding an investment for a year to qualify for long-term gains can be beneficial tax-wise, it’s not always the best decision. If the company is facing challenges or if you have concerns about its future performance, it may be smarter to exit the position even if it leads to short-term capital gains. It’s also important to remember that you can use losses from other investments to offset these gains.

Managing Company Stock and Concentrated Positions

Many of our clients find themselves with large unrealized gains in company stock or concentrated positions that they’ve held for years. When more than 10% of your portfolio is concentrated in one holding, it’s wise to consider taking some profits and diversifying. For instance, moving these gains into index ETFs can reduce risk and potentially offer more growth opportunities.

Concerns about the taxes due from realizing these gains are common, but holding onto a position simply to avoid taxes can backfire, especially if the stock price declines. You can gradually exit these positions over time, but in many cases, especially after a substantial run-up, taking the gains and reallocating them can be a safer and more profitable strategy.

Liquidity Needs

If you’re nearing retirement or planning a major purchase, it’s a good idea to realize gains and move proceeds into cash or more conservative investments like fixed income. By doing so, you avoid having these funds exposed to market fluctuations. When you need liquidity, especially for future withdrawals, it’s important to ensure those funds are not at risk in the stock market.

Other Considerations

There are other instances when it makes sense to take the tax hit on unrealized gains. We’re here to help assess your unique situation and guide you toward the best decision. While taxes are an important part of the equation, they should not dictate every move in your investment strategy.

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