4 Steps for Creating a Capital Gains Budget

Strong market performance can leave investors wondering whether it's time to pocket some gains. At the same time, the prospect of capital gains taxes and the loss of potential upside that comes with cashing out often dissuade many people from doing so.

"The idea of clicking the 'sell' button can be a significant psychological barrier," says John Byers, a Schwab senior financial planner based in Westlake, Texas. "But investors often forget that a gain isn't truly yours until you realize it."

To alleviate some of that concern, John works with clients to create a capital gains budget, which aims to minimize tax exposure when realizing profits. Creating such a budget entails:

• Considering your overall financial plan: Your liquidity needs, portfolio concentration, and other priorities, such as philanthropy, should all play a role when setting your budget. For example, you might reserve your most highly appreciated securities for your charitable goals, since donating them generally allows you to bypass the capital gains hit entirely and secure a deduction for the full fair market value of the gift.
• Setting an annual gains target: Consider how much capital gains you can afford to realize without pushing your total income into a higher tax bracket. From there, determine a dollar amount or portfolio percentage to guide your sales throughout the tax year.
• Prioritizing investments you've held more than a year: Assets held less than a year are typically taxed as ordinary income—as opposed to the more-advantageous long-term capital gains rates of 0%, 15%, or 20%, depending on your income. (If your modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly, you may also be subject to a net investment income tax of 3.8%.)
• Tax-loss harvesting: Selling underperforming positions to offset your winners reduces both your capital gains tax liability and your taxable income for the year.

"A capital gains budget helps you reframe your thinking from How can I avoid paying taxes? to How can I access my money most tax-efficiently?" John says. "It's a lot less daunting once you put a plan in place to tap your assets effectively. And it's meant to be dynamic—you can always make adjustments."