Don’t wait until later in the year to do year-end investment tax planning. The start of fall is the best time to make and begin implementing your plan.
Year-end planning – with accompanying asset sales – will occur later in the year for most people. Mutual funds will do their fiscal year-end sales in late September or October. Those factors often push down prices. By doing your planning now, there will be more time to carefully consider your plan and to beat the rush by not letting these crowds alter the results of your plan.
There are three basic strategies you want to consider: loss harvesting, taking gains, and charitable contributions.
Loss harvesting is a widely-discussed strategy that rarely is implemented. Any investment with a paper loss should be considered for at least a short-term sale. The capital loss offsets any capital gains for the year. In addition, when losses exceed gains for the year, up to $3,000 of the excess losses can be deducted against other income. Any additional losses can be carried forward to future years until exhausted.
Selling losses to offset gains and other types of income greatly increases after-tax returns. Reducing taxes on your gains is better than leaving a paper loss on your account statement. In addition, the cash from the sale can be re-invested in an investment with better potential.
Suppose you want to own the losing investment for the long-term, believing it will turn around.
You can do that and still sell to deduct the loss if the “wash sale” rule is avoided. The rule simply is that you cannot buy a substantially similar investment for more than 30 days after the sale of the losing investment. That means sell the investment, wait more than 30 days (not 30 days, but more than 30 days), then re-purchase the investment. You take the risk that the investment will make a substantial move during the 30 days.
You might not have to stay out of the market for more than 30 days. You can buy an investment that is not considered substantially similar. For example, if you have a loss in American Century Emerging Markets fund, sell it. Immediately purchase an emerging markets fund from another fund family. The two funds will have different holdings, so they should not be considered substantially similar. If your losing investment is a stock, you can purchase the stock of a competitor in the same industry.
The IRS has not ruled in detail on the “substantially similar” issue. It is not clear if you can sell an index fund of one fund company and buy a fund that seeks to track the same index at another fund company.
You have to consider transaction costs when planning loss harvesting. There are costs to buying and selling thinly-traded stocks or mutual funds with redemption fees or trading fees. Even widely-traded stocks incur commissions on trades. You have to be sure that the tax benefits will exceed the costs of the transactions.
The best case is that you sell before the crowd, locking in your deduction. Everyone else sells and drives the price down further. Then, you repurchase the investment at the lower price.
After harvesting your losses, consider taking some profits. Our Retirement Watch recommended investments are sold only when we think market trends are getting ready to change or an investment is overvalued. But you might own other investments with gains and are wondering whether to sell them.
I generally recommend taking a gain when an investment’s valuation means there no longer is a margin of safety. You also should sell if the trends that made the investment profitable seem likely to change.
Here’s a quantitative way to determine whether to take a gain. Suppose you purchase a stock for a total of $5,000, and your position now is worth $10,000. You owned it more than one year, so the potential tax is 15% of your $5,000 gain. That makes your imbedded tax bill $750. That is 7.5% of the stock’s current value. If you think the stock is unlikely to decline more than 7.5%, then there is no point in selling. The tax bill from selling would exceed your potential market loss.
But if you think a turn in the market easily could exceed 7.5%, then it makes sense to sell. Your “loss” from paying the taxes is less than the potential market loss. In addition, if you wait to sell until after the market declines, you will suffer the market loss and still owe taxes on whatever gain you have at that point. The hitch is that the tax loss is certain. If you sell, you will owe the taxes. The potential market loss is speculative. The stock might continue rising, or the loss could be less than 7.5%.
If you have decided to take a gain, there is a strategy to consider instead of selling. Consider donating the security to a charity. You get a tax deduction for the fair market value of the security and owe no capital gains taxes on the gain.
Most major charities are set up to accept donations of publicly-traded stocks and mutual funds. Making the donation takes more time than selling. Most brokers require you to complete a form and mail or fax it to them. You need information from the charity that will receive the security, such as the broker at which its securities account is located and identifying information of the account. Your signature might have to be notarized or guaranteed.
If you were considering making donations to charity during the rest of the year, or early next year, consider donating an appreciated security instead. You will be able to contribute the same amount of wealth at less cost to you.
Let’s return to the prior stock example. Since you will owe $750 in taxes by selling, the real value of the security to you is only $9,250. But you can capture the full $10,000 market value by donating the security to charity. In addition, if you itemize deductions, the $10,000 is deductible as a charitable contribution. (A high income person might loss some of the deduction because of the itemized deduction reduction.) If your state and federal tax bracket is 40%, you save $4,000 in taxes. The bottom line is better than from selling the security, paying the taxes, and writing a $10,000 check to the charity.
It can make sense to donate the security even if you want to continue owning the stock.
Suppose you have decided to contribute $10,000 to your church this year. Your intention was to write a check, because you don’t want to sell any of your securities. You can write the check and take the $4,000 reduction in taxes.
A better route might be to donate the security. You get the same tax reduction. Then, add the $10,000 cash to your securities account. Repurchase the same stock. Now, the tax basis of the stock is its current fair market value. The stock really is worth $10,000 to you, because there no longer is any embedded tax from the gain. The wash sale rules do not apply when you had a gain in the security. You do not have to wait 30 days before purchasing the stock. You can put the cash in the account in advance and repurchase the stock the same day it is donated.
This strategy would be especially appropriate with some of our Core Portfolio investments. Longtime readers accumulated big gains over the last few years, unlike index investors. Add some cash to your account while preparing the paperwork to donate some fund shares from the Core Portfolio to your favorite charity.
Before we get into the holiday season turmoil and the tax selling of others roils the markets, get your plan in place. Consider selling investments that show losses. For investments with big gains, consider selling or donating the securities.