The stock market can be volatile, and the value of an investment can go up or down at any time based on news, current events, and overall market conditions. And stocks aren't the only asset that can gain or lose value; other investments, like bonds and mutual funds, can also rise and fall depending on a number of factors.
If you're an investor, it can be nerve-wracking to watch your portfolio's value drop -- and thrilling to watch it soar. But the important thing to remember is that you don't actually make or lose money until you sell your investments. When you sell an asset, your gain or loss becomes realized, and you either make or lose money on your original investment. By contrast, unrealized gains and losses only exist "on paper"; they're not real yet, because you haven't made a transaction.
This is an important distinction not only for the reasons above, but also because realized gains and losses, unlike unrealized gains and losses, can affect your taxes owed -- for better or worse.
Realized versus unrealized gains
When the value of an investment exceeds the price you paid for it, that's considered a gain. Whether or not you actually profit from that gain is a different story. Let's say you buy 100 shares of Company X's stock at $10 a share, and months later, the price jumps to $15 a share. If you were to sell those shares, you'd stand to make a $500 profit. But if you didn't actually sell those shares, you wouldn't make any money. That's the difference between a realized and an unrealized gain.
A realized gain is the profit from an investment that's actually been sold, as calculated by the difference between an investment's purchase price and sale price. An unrealized gain, by contrast, is simply a gain on paper. Realized gains are taxable, so if you sell an investment at a profit, you'll need to report that income and pay capital gains taxes. On the other hand, if the value of one of your investments goes up but you don't actually sell it, it won't impact your taxes.
Realized versus unrealized losses
When the value of an investment drops below the price you paid for it, that's considered a loss, but whether or not you actually lose money depends on what you do with the investment in question. Let's say you buy 100 shares of Company Y's stock at $10 a share, and a few weeks later, the price drops to $5 a share. If you were to sell off those shares, you'd lose $500. But if you sat tight and did nothing, you may not lose a cent.
Just like gains, losses are unrealized until investments are liquidated. If you're sitting on an investment that has lost value and you don't need to sell it immediately, then you may be better off waiting to see if its value climbs back up.
On the other hand, sometimes your best option is to sell a losing investment in order to cut your losses and lower your taxes owed. Capital losses can be used to offset capital gains for tax purposes. If you realize $1,500 in capital gains in a given tax year, and you also realize a $1,000 capital loss, then you'll only owe taxes on $500 in gains. Furthermore, if your realized losses exceed your realized gains for a given tax year, then you can deduct up to $3,000 of the remaining losses from your taxable income. And if your net losses exceed that $3,000 threshold, then you can carry the remainder forward to future years.
Keeping tabs on your portfolio's performance can help you make smart decisions when it comes to selling investments and paying taxes. Try not to panic the next time you see your investments decline in value. An unrealized loss might weigh on your mind, but you won't actually lose money until you make a move.
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