Let Me Clarify

Let’s be honest – capital gains can be confusing. Most investors with non-qualified accounts, at one point or another, have received a 1099 at the end of the year and wondered what exactly these “capital gains/losses” are and where they come from. This can sometimes lead to frustration at tax time as well as misunderstandings regarding who has control, if any, over these distributions.

Before we get into the details, let’s take a step back for a refresher on the type of account this applies to.

What is a “non-qualified” account?

Simply put, non-qualified accounts are those that do not satisfy the requirements for preferential tax treatment. Unlike IRAs, 401(k)s, and other “qualified’ accounts, these plain-vanilla investment vehicles are not eligible for deductible contributions, tax-free withdrawals, or other major tax benefits.

That doesn’t mean that they aren’t a great option though! Non-qualified accounts may not have many direct tax benefits, but there are no income phaseouts, no contribution limits, and there are no age restrictions on withdrawals. For these reasons, it can be a great opportunity for those who have maxed out qualified account contributions, been phased out due to high income, or simply for those seeking increased flexibility instead of specific tax benefits.

What are “capital gains/losses”?

Capital gains and losses are determined by the increase or decrease in value between when an investment is bought and when it is sold.

• If you buy stock A and then sell it at a higher value later, you have a capital gain.
• If you buy stock B and then sell it at a lower value later, you have a capital loss.

In addition to an increase or decrease in value, how long you hold the investment also makes a difference.

• If you held the investment less than a year, this is considered a “short-term” gain/loss.
• If you held the investment more than a year, this is considered a “long-term” gain/loss.

More on that later.

How are capital gains triggered?

As mentioned above, capital gains/losses are triggered when investments are sold by an investor or advisor. So, when you decide to take a withdrawal from a non-qualified account or decide to rebalance those investments, that triggers a capital gain/loss event.

However, even if you do not sell or rebalance throughout the year, capital gains can still be “spun off” depending on the investments that you hold. For example, mutual funds and ETFs can have transactions take place within the funds themselves that cause capital gains to be paid out to the investors who hold them. So, when a mutual fund manager decides to rebalance the holdings inside of the fund, or to simply sell something to raise cash, those holdings could have embedded gains over many past years.

This is likely the answer when investors ask how they have capital gains in years when their investment performance is negative, and they didn’t actively sell any investments.

How are capital gains taxed?

Understanding the entirety of capital gains taxes would be a lengthy discussion – maybe something we can tackle in a future post.

For now, I’d like to leave you with two important components:

1. Short-term and long-term gains are taxed at different rates. Short-term gains are taxed at the same rate as your ordinary income, while long-term gains are taxed at lower rates. This is why most advisors and investors emphasize not buying and selling investments in the same year.
2. Gains and losses can offset each other. For example, if Investment A is sold with a $500 capital gain and Investment B is sold with a $500 capital loss, those will typically offset each other, resulting in no gain or loss for tax purposes.

Circling back to where we began, capital gains can be confusing and much more complex than what I’ve covered here. However, remembering the items above will create a solid foundation for when we dive a bit deeper in the future and will hopefully set you off on the right foot with planning around your non-qualified accounts and bringing some tax efficiency to them.