By: Alec Lance
No one likes to pay taxes. Full stop. For financial planners, this is abundantly clear. Yet, some investors have a greater aversion to paying taxes than others. At the end of the day, paying taxes is necessary, unless you fancy the Franchise Tax Board seizing your home, or worse yet, being sentenced to live in a concrete cell. In fact, paying capital gains taxes can be to your benefit!
One of the five facets of proper financial planning is tax planning. The hard thing with tax planning though, is that it’s unique for each investor. It depends not only on their aversion to taxes, but also on their other taxable income, risk tolerance, liquidity needs, and more. These personalized considerations can make generalizing about taxes very misleading.
Regardless, most people will raise an eyebrow if they get a big capital gains tax bill during a poor market performance year, like 2022. However, there are a few more nuanced considerations to think about if you see realized capital gains on your year-end taxable investment account statement during a poor performance year.
Consider that the stock market and taxes do not necessarily work on the same calendar. Was the market bad the full year? In the case of 2022, it has been. The S&P 500 hit its intra-year high on the second trading day of the year (1/4/2022 @ 4818.62). In other years, like 2018, the market dropped quickly at the end of the year, to more than erase its gains for the year. On average though, the amount of realized capital gains during a year like 2022 should be less than during a year like 2018. Nevertheless, the timing of the realization of capital gains can be important.
To illustrate this idea, consider that during 2021, the S&P 500 was up nearly 27% (on top of ~16% gains in 2020 and ~29% gains in 2019)! So, while one may be more willing to realize capital gains during 2021 (versus 2022), and pay the associated taxes, in retrospect, a worthy investment manager may have pushed off some realized capital gains to January of 2022, to help reduce or spread out the tax burden. If that were the case, their timing would have been impeccable, even if only out of sheer luck! The investor should be happy to accept capital gains here, because, had the sales not occurred in January, they likely would have lost more money after the market fall ensued.
Even during a bad full year like 2022, some investments can still perform quite well, which can lead to the realization of capital gains. During 2022, the best example of this is the energy sector. Year-to-date, XLE, which is a leading, diversified energy sector ETF, is up a whopping 67% (as of market close on 11/8/2022), while the S&P 500 is down 19% over the same period. When this extreme divergence happens, it can lead to the realization of capital gains. While this may seem counter-intuitive at first, it is important for investors to understand why.
Reason: another facet of financial planning is risk management. This example illustrates a situation where risk management may warrant selling (at least some) XLE during the year, to prevent it from becoming too large of a portion of the overall investment strategy. To reduce risk, it may be prudent for the investment manager to sell and realize some capital gains. Often, sales like this can be (somewhat) offset by also selling losing investments to realize a similar-sized capital loss. Tax-loss harvesting like this is a valuable strategy that a skilled investment manager will use to limit their client’s capital gains taxes over time, and hopefully help compensate for their professional service fees.
Arguably, risk management may be the most important facet of financial planning for investment advisors, particularly if they’re held to a fiduciary standard (which WCF is). Reason being that most clients who partner with a financial planner have been saving their entire lives to prepare for their retirement years and to achieve their goals. It is the investment manager’s job to ensure that the investment strategy does not unnecessarily expose those life savings to excessive investment risk.
Upon retirement, most investors rely on their investment portfolios to fund their lives. As a result, a sound investment strategy will ensure there is ample cash available, along with income producing investments that pay interest and dividends to fund withdrawals. Sometimes though, depending on the investment strategy and investor liquidity needs, these sources of cash are not enough to fund the required withdrawals. The investment manager may need to systematically sell investments throughout the year to create enough cash for the investor’s needs. This can be made worse for investors with larger, one-off liquidity needs in a given year, even a bad investment performance one. Considered in conjunction with the two points above (timing and risk management), hopefully the realized capital gains tax bill will still be reasonable, particularly when comparing a bad market performance year (2022, for example) to a good one (2021).
While not the most exciting of concepts, hopefully this has provided clarity about some important tax considerations that we’ve found can be more difficult to keep in mind during a year like 2022. When you receive your 1099 for your taxable brokerage account for 2022, please consider the timing, risk management considerations and your liquidity needs when assessing any realized capital gains. If you have questions about your realized capital gains, do not hesitate to ask your advisor for clarification. Clear communication and healthy alignment of expectations around taxes is paramount to a successful, long-term partnership between investors and their financial planner. At the end of the day, it is still acceptable to loathe paying taxes, maybe even more so during bad market performance years. However, this article will hopefully help you recognize that at times, it can not only be a necessary evil on the path to helping you accomplish your goals, but can also be to your benefit!