Capital gains exposure can add up if you’re not careful. The best way to avoid them is to be mindful of where you’re vulnerable when you’re building your portfolio.
Capital Gains Taxes – What they are, and how they happen
Internal capital gains are an increase in the value of an investment that makes it worth more than the purchase price. As you probably know already, that gain isn’t realized until the asset is sold.
However, sometimes there are internal gains held inside a mutual fund. When the fund manager sells the stocks inside, this will create a taxable event for you. Even though you did not sell anything you will have to pay taxes on the transactions they make.
Note that these capital gains taxes only apply to taxable investment accounts, which includes stocks, bonds and mutual funds. So when your funds grow based on how the stock market is performing, you owe taxes on the investment income.
How to Limit Your Exposure
Depending on how an asset performed throughout the year, you might be caught off guard by a hefty capital gains tax. But there are ways to protect yourself from incurring massive fees.
First of all, you could allocate some of your investments to index funds – and especially exchange-traded funds (ETFs.) Index funds are very similar to mutual funds in terms of being subject to taxes.
Active mutual funds are bought and sold by the managers who are constantly trying to re-balance the fund in terms of the market. Those sales can create capital gains for shareholders.
Index funds, on the other hand, track an index, and are judged on tracking error. So there are less selling “events” that result in capital gains taxes for the investor.
How to Avoid Large Capital Gains Taxes
Overall, the basic rules of a healthy portfolio apply in avoiding capital gains taxes. Have a balanced, efficient investment portfolio.
Think about allocating your more income-producing funds in your tax-deferred accounts and your growth funds in your taxable accounts.
You should also check out your internal capital gains exposure. Morningstar.com provides this information for free.
But you should still be aware of your capital gains exposure. One way you can do this is to check out Morningstar’s capital gains exposures on your mutual funds. Here are the steps to find the internal capital gains exposure for American funds:
Step 1: Go to Morningstar.com
Step 2: Type “American fund” (or whatever you’re looking up) into the search bar
Step 3: Select “price”
Step 4: From there, you can see the listed potential capital gains exposure.
There’s no rule of thumb for what a “good” potential capital gains exposure is, and as the markets have gone up, it’s common to see it in the 20% or 30% range. But generally, the lower the number, the less you’ll risk capital gains taxes.
Do you need help deciphering your portfolio? Contact me today to set up a meeting to talk about your goals.