Welcome to the Weekly SUMmary - 11/27/2020
What are Capital Gains?
According to this IRS page, Capital Assets are virtually anything of value in our possession.
If your assets are held inside a retirement account, you need not be concerned, as the funds in the account have either already paid taxes or taxes are not due until distribution from the account. Non-retirement assets will be subject to Capital Gains/Losses.
There are many different ways that Capital Gains can be taxed. Tax rates will typically depend on whether they were Short Term Capital Gains (STCG) or Long Term Capital Gains (LTCG). This is dependent upon what type of asset is held and how long it was held prior to taking a gain or loss. The rate at which you are taxed can vary greatly from as little as 0% up to Ordinary Income (OI) Tax Rates. Capital Losses may be allowed to offset gains or even be carried forward into future tax years.
This time of year, many investment companies distribute Capital Gains. Let's look at an example of a couple of funds and how investors may respond to each situation.
Fund A holds a few investments. Most have done well through a pandemic, but a couple have significant losses. Investors panic and half leave the fund. In order for the portfolio team to generate cash for distribution, they must sell investments. As the team chose all investments for a reason, they believe that even though some have not performed, they will in the near future, so they are forced to sell those with gains. This causes Capital Gains distributions to all those still holding the fund, even though the fund is down 10% for the year. Investors wonder how they have to pay taxes on gains when their holdings are 10% lower than at the beginning of the year.
Fund B is similar to Fund A although the gains and losses are not as dramatic. The fund is flat on the year. Regardless, investors are still paranoid and flee the fund. The portfolio team again has limited options and sells the investments with gains, causing Capital Gains distributions to investors, even thought the fund is even for the year.
If a fund had to sell losses, gains may be offset. If the fund has nothing but losses, then the investor may be able to use those to offset gains elsewhere or carry the losses forward into future years.
To clarify a potentially confusing aspect. Those that sell, in this situation will face a gain or loss, as applicable, but the investors that are not transacting will also feel the ramifications, even if staying invested.
There are many types of investments and many ways that Capital Gains are handled. In order to understand your situation, you need to understand your investment and how capital gains/losses are handled related to those investments.
The content in this blog is not meant to be construed as advice or recommendations. Prior to making any decision on transactions, consult your financial and tax advisors. All content has either been referenced or is knowledge gained through studies of advanced degrees or experience in the financial services industry. LPL Financial and its representatives do not offer tax advice.