Appreciation is defined as the growth of an asset’s value over time. Along with income, appreciation of capital is the most common objective for investing in a particular instrument.
Appreciation is the backbone of many retirement planning strategies. After all, the whole point of investing your money is so that it can increase and build your nest egg.
Types of Appreciation
Appreciation can happen in several different ways, depending on the type of investment.
Stocks are priced according to supply and demand. Shares of a company might appreciate when investor sentiment is positive and demand for the stock is high.
Bond yields and prices move inverse to one another. This means that in a low-interest rate environment, the value of existing bonds with higher interest rates goes up. If you own a bond that has a higher interest rate than ones that are currently being issued, you can likely sell it at a higher, appreciated value.
Mutual fund shares are priced according to the value of their underlying assets. Appreciation of mutual fund shares will depend on how the fund assets perform.
Fixed and indexed annuities appreciate as interest is credited to their value.
Tax Considerations of Appreciation
The government taxes the appreciation of an asset according to the type of investment and the type of account holding that investment.
If the value of a stock appreciates, the gain is only taxed if it is realized. That means the stock is sold at a profit.
Most investors hold bonds until their maturity, so changes in the bond’s value are not realized. However, if you sell a bond prior to its maturity and the value of the bond has appreciated, the IRS taxes you on the gain in the year you sell it.
The gain on appreciated mutual fund shares is taxed in the year the shares are sold. Mutual funds also have an additional layer of taxation when the underlying assets appreciate. If the fund manager sells an appreciated part of the fund’s portfolio, then the tax on the gain may be passed onto the fund’s investors.
Appreciation in Retirement Planning
When it comes to appreciation in the context of planning for retirement, the value of holding assets in individual retirement accounts (IRAs) cannot be overstated.
For assets (such as stocks, bonds and mutual fund shares) held in an IRA, appreciation is not taxable to you until you actually start taking withdrawals from the account. This allows you to defer taxes until retirement regardless of when you buy or sell assets.
This frees you from having to consider taxes when timing the purchase and sale of investments. When you start taking income from your IRA, it is taxed as ordinary income, as long as you are at least 59½ at the time of the withdrawal. Income taken before 59½ will incur a 10% IRS tax penalty in addition to ordinary income tax.
The taxation of appreciated annuities follows the same approach, as long the annuity is held in an IRA. Non-IRA or “non-qualified” annuities work in a similar fashion. If they are funded with money that has already been taxed, only the gains are taxed once income begins.
