She's in her early 30's and was recently promoted at work. She maxes out her 401(k) each year and does a little investing on the side via the market and other equities.
She's getting small dividends from stocks and interest from other fixed income assets like bonds and savings. She may also be investing in some exchange traded funds (ETFs), mutual funds and working with an advisor to consistently rebalance her portfolio to meet her future goals.
It's that trading or rebalancing of her portfolio that often creates long or short-term capital gains or even losses. But let's not get carried away with the jargon.
Basically, capital gains are gains that are a tax liability to you at the end of the year and the losses help your taxes when Uncle Sam comes calling in April.
Erica may look at her overall portfolio, its total value and see it's around the same as it was at the beginning of the year, but her adviser may have adjusted things during a very turbulent year. All that trading and moving investments around could become a tax liability on April 15.
It's important to note that her 401(k) contributions and any gains on that investment are tax-free, so let's put a pin in that topic for now. But her active portfolio is what we are focusing on here.
So, what could Erica have to worry about? Realized gains if she sold any investments at a profit and capital gains distributions if she has a fund manager working for her selling positions that were up during the year.
Is there anything Erica can do?
In short, yes!
James Beam, the Head of Investment Advisory at TD Wealth, says this is when you can "harvest" losses.
Unless you have a crystal ball, you probably have some investments that are down, as much as you have investments that you've seen some real growth in the past six months.
"You sell the investments that are down to offset the gains you've realized or at least lessen them," Beam explained. "So, at the end of the year, the client will have less in taxes to pay."
If that asset is a company or an industry that you were looking to hold for the long-term, as you think there is major growth to be had, minus the short-term losses, what you can do is work with your adviser to buy something similar, so that you're still invested in say aviation, tech or energy, but have also harvested those losses for the year.
Another tactic is changing positions on something like a mutual fund if that fund is set to pay a large capital gain. That gain distribution, even if you reinvest, is going to be a tax liability for you.
"At TD Wealth, we work with our clients to determine what is right for them and sell the fund before the distribution happens if that is in the client's best interest," Beam said. "We reposition the portfolio, possibly into a similar fund with less capital gains. We hold it until the payment period is over and then buy back the other fund. In the end, they get the same mutual fund they had, without the distribution and the tax liability."
Those are two ways to mitigate the tax liability of a portfolio, Beam says.
This isn't just for the short-term either
If you buy and hold a company's stock, a mutual fund, an ETF, over time, you could potentially end up with a highly appreciated asset years down the road.
Now, this is your goal, let's be clear. But when you go to sell that asset later -- whether for retirement, to buy a home, or even for your children's college fund -- you could be required to pay taxes.
But if you and your adviser manage that every year and reallocate from time to time, you could end up with much less of a tax hit when the time comes.
"That's why you rebalance your portfolio and why you harvest losses against gains," Beam said. "You are essentially raising your basis."