How Taxation on Stock Holdings Work
If you buy a certain amount of stock today, you have invested in a company by buying a certain amount of shares. Over time, the price of your stock will fluctuate, and we will generally value our stock by the mark to market method, but you aren’t taxed on the profit you make until it is realized.
So your stock has gone up so much a share down the road, and you could sell it for this higher price, but the fact is that you haven’t, and determining its future value isn’t something that could even be done, as we don’t know what price the shares will bring down the road if it is sold then.
If you own a lot of shares in a company, you likely won’t even be able to sell it at the market anyway. If Bill Gates decided to sell all of his Microsoft stock at once, this is going to flood the market with the stock and by the time the dust settled, buyers for the last of it are going to be buying it for much less than it happened to be trading at the time the sell orders were placed.
It therefore isn’t even accurate to value a company’s stock value by way of the last trade, which might only be 100 shares, and we’re talking what millions of shares are worth when looking at their market capitalization. Even though few investors have enough stock in a company that they are going to affect the price much, what the last trade was isn’t really a meaningful number, especially if the sale is not planned anytime soon.
This is one of the reasons why people shouldn’t necessary worry too much about where a stock is trading if they have no intention of selling it for quite some time, although a lot of people in this situation watch a stock’s price and imagine money going in and out of their accounts with every move.
The Benefits of Deferring Taxation on Unrealized Capital Gains
Luckily, governments do not make this same mistake, and the market valuation at any given time of the stocks that we still own do not factor into anything. It is only when the stocks are sold that this matters, and this does give us the opportunity to defer paying taxes on the money we make from these investments, the capital gains part anyway.
This does not generally require that we hold the same stocks until such time as when we’re ready to realize the capital gains, although if we do use that strategy and just keep the stocks for the long term, without any trading, this will certainly defer the taxation until we’re ready to sell.
A lot of people take advantage of the benefits of retirement accounts to defer taxation, where they can defer both the taxes due on the money invested as well as deferring the taxes due on their capital gains, and it’s certainly a good idea to take well advantage of such accounts.
Governments allow for these accounts in order to encourage people to save more for retirement, which may become even more important as government managed public pensions such as Social Security become less reliable, at least as far as counting on full entitlement.
If you are planning on saving for retirement anyway, it only makes sense to look to benefit from these types of accounts, to seek to minimize the amount of tax you will pay in the end. Every dollar that you don’t pay in tax is a dollar in your own account.
Deferring capital gains tax by holding positions over time is another way to defer taxation on investments, although people don’t often focus on this. If you are doing this to save for retirement, the same rationale applies here as putting money in a traditional IRA, an RRSP, or other similar vehicles, which is to cash in the investments and claim the income in your retirement years, in a lower tax bracket due to your income being reduced.
Strategies for Realizing Capital Gains
You can do the same thing though if you stay in the stock market and maintain your investments until retirement, where you can then liquidate your stock positions as appropriate in order to seek to minimize your overall tax exposure.
If you have a substantial position and you sell everything upon retirement, this may not be the best approach as much of your income may be taxed at an even higher rate than you were paying when you were working. This is because large amounts of capital gains will be added to your annual income, rather than looking to spread this out, which is the better approach usually.
One approach would be to cash in an amount that would not place any of the income in a higher tax bracket, and provided that your tax bracket at retirement is a lower one than when you were working, this would allow you to pay this lower rate on the capital gains as well.
This is going to depend a lot on need though, and you may need to cash in your investments more quickly due to having or wanting to bring your income up to previous levels, or for other reasons, but given that people typically shoot for a lower level of income when in retirement, three quarters for instance, if you look to have your investments top this off to that amount, you still will have a lower income and pay less tax overall.
If you cash these investments in while you are still working, all of the capital gains will be income over and above what you normally earn, so the best you may expect is paying the same tax rate, and often you will pay even more tax than normal with this approach.
There is more to these decisions besides tax efficiency of course, and we may want to get out of the stock market well before retirement in some cases due to not wanting to take on the extra shorter term risk that these types of investments involve, but tax efficiency is certainly something that needs to be looked at as we decide what will be best overall here.
The rule of thumb though as far as realizing capital gains is that you ideally want to do so when your income is lower. The reverse is true with capital losses though, where you want to realize them when your income is higher, to realize greater tax savings.
So it is not just a matter of buying and holding as far as what the best tax strategy is with these investments, and it can certainly be advantageous to exit positions for tax reasons at certain times where money has been lost on them.
There may be rules that may apply such as the wash sale rule, and governments aren’t fond of people just using this rule to manipulate their tax situation, so you may not be able to just sell your stock and buy it right back.
The IRS for instance in the United States makes you wait at least 30 days before you buy a “substantially identical” investment, but 30 days is not a long time to wait and doing so may allow you to realize a tax advantage from a position which has yielded a net loss.
If you do choose to re-enter the market with the proceeds, this also allows you to reset your costs at the purchase price, where you end up writing off the losses at the present time, when your income is higher, and if the price comes back as it often does, you can defer that gain until you are in a lower tax bracket if circumstances permit.
If you bought the stock at $50 a share, and it goes down to $40 for instance, and later goes up to $50 when you sell it, you can realize a tax advantage even though the stock hasn’t moved at all during this whole time.
If your marginal tax rate was 33% at the time of the first sale, and it went down to 25% at retirement, in this example you would have written off the $10 per share loss at the higher rate and then claimed the $10 gain at a lower tax rate, which ends up saving you money.
The real key when looking at potential tax savings through this approach is not to allow these tax considerations to overly influence your decisions, but if it makes sense to be in the stock market anyway, this can present some real tax advantages if handled properly.