Your goal as an investor should be to make money, and you can do that in a number of ways. You can buy stocks that pay dividends and pocket that cash, or you can sell stocks at a share price that's higher than what you paid and bank the difference.
When you sell stocks at a profit, the result is capital gains -- and the IRS is definitely going to want a piece of those. As such, while sitting on a massive gain is a good problem to have in theory, because it means you've made a killing on a stock you owned, it could also pose a problem from a tax perspective.
Thankfully, there's an effective solution to this problem: a tactic known as tax loss harvesting. And if you use it strategically, your enormous gain may not be such an issue after all.
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Negating gains with losses
The extent to which you'll be hit with a whopping tax bill on your capital gains will depend on how long you held your stock before selling it. If you held it for a year or less, you'll be subject to short-term capital gains taxes, and those can be expensive because they're the same marginal tax rate you'll pay on ordinary income.
If you held your stock for at least a year and a day before selling it, the pain won't be as bad because you'll be bumped into the more favorable long-term capital gains category. Long-term capital gains taxes amount to 0% for low to moderate earners, 15% for moderate to high earners, and 20% for the very wealthy. These rates are much lower than ordinary income tax rates, so it generally pays to hold investments for at least a year and a day before selling them off, if that's possible.
Now, let's talk about how to negate some or all of those gains. The solution is simple: Sell underperforming stocks in your portfolio at a loss. Capital losses can be used to offset capital gains, so if you take a $6,000 loss and are sitting on $10,000 in gains, you'll only be subject to taxes on the remaining $4,000.
Keep in mind that capital losses are first applied to gains of the same nature. In other words, if you lock in a long-term capital loss, it will first be applied to your long-term capital gains, and then any amount left over will be applied to short-term gains. That's an important distinction, because it could impact the investments you choose to liquidate first.
Another thing you should know is that if you happen to have a major loss on your hands (enough to offset all of your capital gains and then some), you can use the remainder to offset up to $3,000 in ordinary income per tax year. And any remaining loss you have after that can be carried over to the next tax year.
Sell investments strategically
Having a large gain on your hands could mean that you chose your stocks wisely and sold at the right time, but it could also spell trouble from a tax perspective. Selling other investments at a loss is a good way to cancel out what could otherwise be a giant tax bill.
And if you don't have any investments to unload at a loss, prepare to pay estimated quarterly taxes on your gain during the year. Doing so will help you avoid being penalized by the IRS for underpaying your taxes.
