Last year was a great year for equity investors, but as you count your gains, remember that last year's prosperity can be this year's tax problem. All those gains may have turned your portfolio into a ticking tax time-bomb.

The S&P 500 was up nearly 30% in 2013. Any U.S. stock portfolio should be looking much fatter as a result, but keep in mind that if your portfolio is taxable, you will have to give some of that increase back in the form of realized gains taxes. What's more to the point, the real tax liability may be waiting to hit you in the 2014 tax year.

The dangers of unrealized gains

While you may have racked up around 30% worth of paper gains in 2013, unless your portfolio is managed in a high-turnover approach, chances are that much of that increase is in the form of unrealized gains. If you have not done so already, you should tally up your realized gains from last year, just so you will have a feel for what kind of tax bill you will be looking at this April.

More importantly for planning purposes, you should also look at the magnitude of unrealized gains in your portfolio. Since investment gains are only taxed when you sell a security, the large unrealized gains that can build up when a portfolio has a strong year can become a problem in future years. For example, your portfolio might only break even in 2014, but if you sell any stocks that were up big in 2013, you may face a tax liability for this year that exceeds your investment return.

How can you defuse this ticking time-bomb? The truth is, you cannot expect gains without paying some taxes, but there are ways you can manage the impact of a large build-up in unrealized gains. Here are five suggestions:

  1. Don't count your chickens. When revaluing your portfolio for planning purposes, you may want to discount the market value by the amount of any large, unrealized tax liability.
  2. Build up a tax reserve against unrealized gains. This is to make sure your cash flow can handle the future tax liability.
  3. Avoid timing traps. Make sure you don't sell just as a stock is about to go long-term or a calendar year is about to end.
  4. Audit your portfolio for weak links. You shouldn't sell stocks just because they are down, but if a stock is down and its business prospects have diminished, getting the tax benefit of realizing the loss can take some of the sting out of a failed investment.
  5. Consider substitutions as another way of realizing losses to offset gains. Wash-sale rules prevent you from re-purchasing a stock on which you are claiming a loss for 30 days, but if you own a group of stocks purely to capture that sector, you may be able to find a group of suitable substitutes you can buy immediately so you can realize losses on the original group.

Always remember, taxes on gains are a sign of a healthy portfolio. In other words, it's a good problem to have.

The original article can be found at Money-Rates.com:
Is your portfolio a tax time-bomb?