Understanding Unrealized Capital Gains & Their Impact On Your Tax Situation

One of the biggest goals of many investors is to achieve capital gains. Once you do, however, you might be wondering what’s the best course of action. Do you hold onto your gains or do you realize them? And how does all of this impact your tax bill?

While your unrealized gains may not be subject to a capital gains tax rate, understanding their impact on your tax situation is critical to your overall tax planning.

What Are Unrealized Capital Gains?

When investing, a gain refers to when the price of the asset increases above the amount the investor originally paid. Gains can be separated into two categories: realized and unrealized. A realized gain occurs when an investor sells their asset for more than they bought (the gain is “realized”). Conversely, an unrealized gain occurs when an asset’s price increases, but you haven’t sold it (the gain remains “unrealized”).

Calculating your unrealized gains is relatively straightforward. For example, if you purchase 80 shares of stock ABC at $10 per share, your original investment is worth $800. If the market value later increases to $15 per share, the investment’s worth would be $1,200. In this case, your unrealized gain would be $5 per share, or $400. If you chose to sell your shares at $15, you would then realize that $400 gain.

What They Mean for Your Tax Bill

While individuals with net wealth above $100 million may face an unrealized gain tax in the future, most people don’t need to worry. Usually, there’s no tax on unrealized capital gains because they aren’t considered taxable income; they’re simply “paper profits.” When you go to sell and turn those unrealized gains into a real profit, then you would need to pay the capital gains tax.

Although unrealized gains don’t carry any tax liability, understanding how they work is a valuable tax planning tool that can give you an idea of what you would owe if you decide to sell and help inform important decisions regarding your investments.

To understand the potential tax consequences of your capital gains, you need to consider how long you’ve held your assets. If you experience short-term capital gains, which apply to assets held for one year or less, and you decide to sell, you would be taxed on your gains at your ordinary income tax rate.

Long-term capital gains, on the other hand, apply to assets you’ve held for over one year, and they’re taxed differently. The Internal Revenue Service (IRS) assigns these tax rates according to where your income falls within three thresholds. For the 2022 tax year, these thresholds are:

To Sell or Not to Sell?

Once you know the potential tax implications, deciding whether to realize your gains can be a difficult decision to make. After all, capital gains may look appealing on paper, but actually realizing them (and paying the associated taxes) is a hurdle many people don’t want to face. Additionally, people may want to preserve their unrealized gains on the chance that the value continues to increase.

However, holding onto gains comes with risks. There’s always a chance market volatility could offset the value of deferring your gains. Your unrealized gains could also build up to the point that you end up in a higher capital gains tax bracket when you go to sell, which could result in a loss of wealth.

At the end of the day, the decision to hold onto versus realize your capital gains comes down to your unique risk tolerance and time horizon.

The Bottom Line

How you handle unrealized capital gains can have a significant impact on your portfolio and tax situation. To ensure you’re making well-informed decisions, consult with a tax professional at Ironwood Wealth Management. With our holistic approach to financial planning, we’re here to add value whatever your needs or objectives may be. Contact us today to learn more.