Saturday, June 8, 2013

7 Year-End Tax Planning Strategies For Investors

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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