Richard Feldman for TheStreet writes: Nobody likes paying more taxes
than they have to but that is exactly what the average investor does.
How? By failing to implement strategies that can increase his or her
long-term, after-tax return. The U.S. tax code provides planning
opportunities for taxable investors when capital investments lose value.
Unfortunately, many people foolishly cling to investments that were
made in equities and real estate in the hope that the investment comes
back in value. This might seem like the logical way to make money in
investments because everything you have ever heard advises against
selling assets when markets are going down; however, the U.S. tax code
is anything but logical.
Offsetting Losses
This year end would be an optimal time to review your
taxable investments and implement strategies that can increase your
long-term, after-tax rate of return. Do you have a capital loss that
could be booked and used to offset future tax liabilities? If so, it may
be time to sell. Plus, if capital gains rates increase, the losses you book now will become even more valuable in the future.
Tax-Loss Harvesting
Investors who have taxable accounts should look at their portfolios
every December and see if there are any capital losses that might be
realized. Selling your losers or booking tax losses now can help you
offset the future tax liability created when you sell an investment at a
gain. Investors in high federal and state tax brackets should try and
offset short-term gains if possible. Short-term capital gains are taxed
at an investor's ordinary income tax bracket, which is as high as 35% in
2009, and may be higher in the future. Long-term gains, on the other
hand, enjoy the benefit of being taxed at a 15% tax rate.
Typically, short-term gains and losses are netted against one
another; the same goes for long-term gains and losses. After the initial
netting of short and long-term losses, the two are then netted against
one another, which will leave you a short-term or long-term gain or
loss. Again, it is beneficial to try and end up with a long-term gain
rather than a short-term gain due to the disparity (up to 20%) in tax
rates on short and long-term gains. If you end up with a loss, either
short or long term, $3,000 of that loss can be used to offset ordinary
income. A $3,000 loss will save you approximately $840 in taxes,
assuming you are in the 28% bracket.
With the advent of exchange-traded funds, tax loss harvesting has become
much easier. If you wanted to take a loss in any particular asset
class, you could sell a mutual fund
and replace it with the corresponding exchange-traded fund for 31 days,
and then move the assets back. This will allow you to maintain the
integrity of your asset class exposure and avoid the wash-sale rule.
Share Identification
Tax loss harvesting might also be used for an investment that has
different tax basis or various lots. Individuals might have purchased
securities at different times and, depending on the price, may have a
gain in one or a loss in another. In situations like this, you can use a
method called lot identification, or "versus purchase" accounting.
Typically, this is done by telling your financial advisor or broker that
you would like to sell a specific tax lot rather than the usual
accounting method of average cost. Your trade confirmation will show
that the shares were sold versus the specific lot you had purchased on a
certain date. This strategy is typically used with common stock rather
than mutual funds. If it is used with mutual funds you will have to
select lot identification accounting from the get-go, rather than
average cost or first in first out (FIFO) accounting.
Wash-Sale Rule
Make sure your tax-loss selling conforms with an IRS guideline
known as the wash-sale rule, which will disallow a loss deduction when
you recover your market position in a security within a short time
before or after the sale. Under the wash-sale rule, a loss deduction
will be disallowed if within 30 days of the sale, you buy substantially
identical securities or a put or call option
on such securities. The actual wash-sale period is 30 days before to 30
days after the date of the sale (a 61-day period). The end of a taxable
year during the 61-day period still applies to the wash-sale rule, and
the loss will be denied. For example, selling a security on December 25,
2009, and repurchasing the same security on January 4, of 2010, will
disallow a loss.
Assess your gains and losses. Individuals should look at Schedule D
of their tax returns in order to determine whether they have any
carryforwards that could offset any potential capital gains
distributions or sales that might create a gain. Individuals who have a
loss carryforward should still harvest any current losses. These losses
may offset any future gains that are made in the stock market or real estate as well.
Year End Capital Gains Distributions
When it comes to mutual funds,
investors need to be careful when purchasing funds at the end of the
year in order to make sure they are not buying into a tax liability,
which can occur as a result of a fund's capital gains distribution.
Mutual funds by law are pass-through entities, which means the tax
liabilities they incur from investments pass through the fund and on to
the shareholder. Funds must pay shareholders 98% of the dividends and
capital gains. Make sure you check the fund company's estimates of
dividends, short-term gains, and long-term gains before you buy them at
year end in a taxable account.
Gifting Appreciated Assets
It is more appealing than ever to gift appreciated assets due to
the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) and extended
by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA).
Giving highly appreciated assets to someone in a lower tax bracket or
charity can effectively reduce or eliminate taxes entirely and remove
the asset from your estate. Due to tax laws, if you gift a highly
appreciated security to an individual in the 10% or 15% bracket, he or
she will only pay 0% or 5% capital gains taxes on the appreciation.
Under current tax laws, if the donee sells the asset in 2009 or
2010 and is still in the 10% or 15% tax bracket, there may not be any
taxes due depending on
the individual's tax circumstances. The one issue you want to be aware
of when gifting to children is the kiddie tax rules, which could have an
adverse effect on the above strategy.
Selling Appreciated Assets
In response to the market meltdown in 2008, Congress passed
legislation that suspended required minimum distributions from
retirement accounts and qualified retirement plans for 2009. Many
retirees, who were often pushed into higher tax brackets because of
distributions from their retirement plans, may now find themselves in a
low tax bracket and possibly eligible for the 0% or 5% tax rate on
capital gains. This might make it an ideal time to sell appreciated
assets in order to fund living expenses over the next couple of years.
This is especially true if long-term rates increase in the future.
The biggest drag on investment performance
is taxes. For taxable investors, proper year-end tax planning will
allow you to keep more of your investment return and pay less to the
government. The economy will eventually start growing and mutual funds
will eventually start paying larger amounts of capital gains. If you
have a capital loss accumulated, your portfolio will be much more tax
efficient in the future. In addition, for individuals in low tax
brackets, the tax advantaged years of 2008 to 2010 are long gone and
long-term capital gains rates will eventually rise, so selling at a 0%
or 5% rate now might be worth it rather than holding appreciated assets
that might ultimately be taxed at a 20% long-term capital gains rate.
Please consult your tax advisor before making any tax decisions.
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