A volatile year in the stock and bond markets means many investors are looking at losses on stocks or mutual funds they have purchased. As we approach the end of 2011 it makes sense to review how you might make these losers pay, or at least use some tax strategy to ease the pain.
The IRS allows investors in stocks, bonds and mutual funds to offset gains against losses in their portfolios. This only applies to assets held in taxable accounts; these include joint tenant accounts, single accounts and certain types of trusts, not IRAs or 401(k)s. The gains and losses must be realized, meaning they must be the result of a sale, buyout or takeover. You will also need to account for the distributions that occur when a mutual fund you own generates a long- or short-term gain from its own buying and selling. Mutual funds must distribute these realized portfolio gains each year regardless of the total return of the fund. This is distinct from dividend distributions, which are taxed differently.
If the investment is held for one year or less, it is considered a short-term gain or loss; the gain is taxed at the same rate as other ordinary income, ranging from 10 to 35 percent. If you have held the investment for longer than one year, it is considered a long-term gain or loss. It is taxed at 0 percent if total income including the capital gain places you in the 10 percent or 15 percent tax bracket. If you are in a higher tax bracket, no matter what the bracket, the gain is taxed at 15 percent.
Here are some steps you can take. First, review with your investment adviser and tax professional the status of all your realized gains and losses for 2011, carry-forwards from previous years, and anticipated capital gains distributions from mutual funds.
Next, list realized gains and losses to date, and anticipated capital gains distributions; divide these into long-term or short-term. Begin by matching long-term losses against long-term gains, and then short-term losses against short-term gains. Now you can review your portfolio for ways to offset remaining gains (by selling a stock that has declined in value) or use losses (by selling a stock in which you have a profit). Make sure, though, that these decisions are not just tax driven, but have a strong investment rationale.
What if you want to sell to take a loss, but wish to continue owning the stock? There are precise rules regarding selling and repurchase of substantially identical securities for tax purposes, called “wash sale” rules. At least 31 days need to elapse between the sale and repurchase; otherwise, the IRS may not accept the loss as a legitimate tax offset. One alternative strategy is to purchase an equivalent amount of the security more than 31 days prior to your anticipated sell date, complete your tax sale, and then retain the equivalent shares. A possible disadvantage to this method — it would double your exposure to the stock for those 31 days. As an alternative, you could find a security to purchase that would perform in much the same way as the security you want to sell, but that wouldn’t trigger the wash sale rule. This could be a similar company in the same industry, or an index fund that tracked the industry. (It’s not advisable to buy the same security in an IRA that you’re selling in your personal account. The IRS has given guidance that this does not constitute an exception to a wash sale.) After planning and completing your tax-selling strategy, any losses remaining can be used to offset up to $3,000 of ordinary income. Unused losses can be carried forward to the following year and beyond, so they can be “banked” to use against future gains.
Tax planning is one of the fundamentals of sound investing practice. Remember that rules regarding tax selling and deductions are complex; and there are many other individual factors which can affect these decisions. Be sure to consult your tax professional.
Steven Weber is the senior investment advisor and Gloria Harris is director of client services for The Bedminster Group, providing investment management, estate and financial planning services. The information contained herein was obtained from sources considered reliable. Their accuracy cannot be guaranteed. The opinions expressed are solely those of the authors and do not necessarily reflect those from any other source.