It used to be a relief to put tax season behind us. But with a goal-directed portfolio, tax planning is a crucial strategy all year long — especially for capital gains tax.

Capital gains are usually the result of an appreciation of an investment asset, which is a key objective for most investors. It means your investment has done well; the approach you and your investment strategist have employed is working and/or the stock you purchased has appreciated. A capital gain is taxed when you sell the asset. Sometimes, paying capital gains taxes from your investment portfolio can actually be a benefit.

When does it make sense to take capital gains?

Many investors choose to defer realizing capital gains in their portfolios (sometimes at all costs.) Doing so, however, may have unintended and/or adverse consequences. The following two examples demonstrate instances when you should consider taking the capital gains in your portfolio and paying the tax.

1. Your financial goal changes, which requires a change to your portfolio strategy.

Situation. You are ready to stop working and will begin using some or all of the assets in your portfolio to support your lifestyle. We recommend that your portfolio shift from a growth- to a stability-oriented strategy.

The purpose for this change is to shift your assets to a more stable investment strategy designed to provide income, reduce risk and manage volatility while supporting your lifestyle. 

Action. You pay X% tax to transition to the more stable strategy; however, you benefit from locking in gains and moving to a strategy designed to generate the needed income for your lifestyle. (In some instances, the reduction in risk to the overall portfolio may more than compensate for the taxes paid as a percentage of the portfolio.)

 2. Your strategy’s good, but it’s time to rebalance.

Situation. Market fluctuations may have caused gains in a portion of your portfolio, and your portfolio drifted away from your target asset allocation.

Portfolio asset allocation accounts for 93% of the variability of returns in your portfolio.1 Deviations from your target allocation may hurt long-term portfolio performance.

Action. The further your portfolio asset allocation structure drifts from the prescribed strategy allocation, the worse the portfolio strategy may perform. Rebalancing — and taking the capital gains — will keep the strategy in place. (Though it’s not the only detractor, we believe the deferral of capital gains is one of the largest disruptors of asset allocation.)

Make smart tax changes

The scenarios above are examples of when your financial goal requires a change to your investment strategy. The cost may be capital gains tax, but the benefit is a portfolio designed to meet your objectives. While realizing capital gains may be necessary, we take every measure to ensure that we manage your portfolio and the gains within your portfolio smartly.2

Tax issues rarely go away on their own. A market pullback may reduce taxes, but it also reduces the value of your portfolio — so it’s just not going to help you in the long run.

The bottom line: What to consider when making decisions about capital gains 

Consider the tax in the context of your financial strategy, not just the number. Here are a few suggestions for how you might approach this decision:

Remember why this strategy works and why it is important to you. Ask yourself:

  • How do I benefit from this gain?
  • How much has the stock increased since I bought it?
  • What is the benefit—or detriment—to me if I leave the security in my portfolio and defer the gain?

Consider what percentage of the portfolio this gain represents. 

For example, a $50,000 capital gains bill may sound large. However, while a long-term gain may represent 20% of the increase in the price of the security, on a $5 million portfolio, it’s only 1%.

Set a capital gains budget with your investment strategist that makes sense for you and for your portfolio. Include:

  • An agreed-upon target asset allocation for each goal-directed portfolio
  • An agreed-upon tax budget that can be applied when you make changes to the portfolio
  • As needed, a tax transition schedule over multiple tax years

This approach can minimize deliberations about the recommended changes to your portfolio.

To learn more, visit our Personal Wealth Management solutions page or call our private wealth management team at 888-551-7872 to learn more.

1 Brinson, Hood, Beebower “The Determinants of Portfolio Performance,” Financial Analysts Journal, 1986
2 One example of this approach is our tax management overlay program that we employ on all separate account strategies. This program, which uses a variety of active tax management techniques, has saved investors an annualized 1.21% in tax alpha since its inception. Includes all mandates run within Managed Account (with tax overlay) since inception 12/2002. As of 12/31/17.

Legal Note

SEI Private Wealth Management is an umbrella name for various life and wealth services provided through SEI Investments Management Corporation (SIMC), a registered investment advisor. SIMC is a wholly owned subsidiary of SEI Investments Company.

Neither SEI nor its affiliates provides tax advice or other legal or regulatory advice. Please note that (i) any discussion of U.S. tax matters outlined in this communication cannot be used by you or any other person for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your circumstances from an independent tax advisor.

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