Too many people sell positions in their investment portfolio without fully thinking through, or optimizing, the tax consequences. It doesn't have to be that way.
If you want to take a distribution without triggering gains, start by looking at selling positions with unrealized losses. (Remember, the tax impact needs to be weighed against the investment considerations, so this isn't always an easy decision.) If you're simply looking to rebalance your portfolio, consider doing so in qualified accounts (such as an IRA or 401k), which are shielded from taxes.
But there's another, often overlooked, tax planning tool available to investors: The Specific Identification Method.
Here's how it works:
When you hold an investment in a regular taxable brokerage account (also referred to as a "non-qualified" account), your "tax basis" is equal to the amount you initially paid for the stock. But more often than not, you didn't purchase the investment at just one time. It may have been a series of purchases, perhaps over several years or decades. If the stock price rose over time (let's hope!), then the more recently purchased shares could have a higher cost basis, and therefore a smaller unrealized gain.
When you look at your position on your statement or in your online portal, you'll typically only see the total unrealized gain or loss. But a peak under the hood reveals multiple tax lots with varying tax positions. Some of your shares may have gains, some may have losses, some may be short-term positions, and others may be long-term positions.
When selling shares under the Specific Identification Method, you are allowed to select the specific tax lot to sell at that time. The other options are the Average Cost Method, First In First Out, and Highest In First Out, all of which give you less control and may result in selling less advantageous tax lots.
By hand-picking the tax lots that are most advantageous to sell, you will be able to reduce your position in a more tax efficient way.
For example, if minimizing current year tax is your goal, you could start by selecting lots with loss positions, then sell long-term positions with the smallest gains. Remember, it’s not always more advantageous to sell the shares with the highest tax basis because short-term gains are taxes at higher rates than long-term gains. In addition, there are certain situations where it may be better to recognize gains than losses (or minimizing gains). This could occur if someone had a large capital loss carryover that needed to be utilized or was in the 0% capital gains tax bracket.
Many people don’t realize that they have the ability to specify the tax lots when selling. By using this method, you’ll be able to rebalance or take portfolio distributions with much greater tax efficiency.