Understanding Capital Gains Exposure

Capital gains exposure is an estimate of how much a taxpayer will owe based on the growth of the value of a stock or share of mutual fund holding. When an investor owns a security and the security's value increases, the investor has earned an income that is taxed in the capital gains portion of the IRS's tax brackets. Investors look to minimize their capital gains exposure on an annual basis through a number of different methods. Minimizing tax exposure first requires understanding tax exposure.

Determining Capital Gains Exposure

To calculate your capital gains exposure on a yearly basis, you will have to use a very simple formula. That formula is:

(Capital Gain of Assets - Loss Carryforward) / Total Value of Assets

If the formula looks complicated, it isn't. In fact, a simple prospectus on your account can give you the information you need to determine your capital gains exposure. If you own a share of a stock that cost $50 at the time of purchase, but is now worth $100, and has a $20 outstanding loss, then your capital gains exposure is:

50 - 20 / 100 or 30%

The stock appreciated by $50, representing a capital gain of 50. This sum minus the $20 loss divided by the current value of the stock gives you the capital gains exposure figure.

Tax Deferred Options

You may own a security that is tax deferred. This is most common with a retirement account where earnings are permitted to grow tax free for a given period of time. 401k earnings and IRA earnings may be tax deferred, depending on the type of account used. With a traditional retirement account, capital gains taxes are paid when the funds are withdrawn. With a Roth option, post-tax dollars are invested and grow tax free from that point forward.

Tax Exempt Options

Some securities are tax exempt. Examples include government and municipal bonds. While there is no need to pay taxes on yields or payment of these bonds, they will rarely see actual capital gains growth, so the tax-deferment will not traditionally assist in lowering a capital gains exposure. Bonds do not increase in value after they are purchased. If they are sold for a higher price than they were purchased for, the profit is treated as income and not capital gains.

Capital Gains in Mutual Funds

Mutual funds are unique in the way they handle capital gains. With a mutual fund, you are purchasing shares of an entire portfolio of stocks, bonds and other investments. These individual underlying securities will see growth in capital gains. However, it is common for the fund to pay out these earnings immediately to share holders. As a result, there is rarely any capital gains exposure to an investor, even if the fund as a whole experiences capital gains. You will instead pay taxes on the earnings as income. This can be more expensive than paying the capital gains tax. One way to change the tax burden is to reinvest earnings instead of cashing out, but this is only advantageous in some scenarios and should be done with the advice of an accountant.

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