In the next few weeks you could add thousands of dollars to your net worth. Market volatility and new tax rules give you the best opportunity in years to reduce your income taxes with year-end moves. Here are some actions to consider between now and Dec. 31 to slash the amount you owe Uncle Sam.
- Prepare your road map. The first step is to estimate your income, deductions, and taxes for the year, assuming you take no further action. Pull out your records year, estimate transactions for the rest of the year, and you’ll have an estimate of this year’s taxes. Once you know what the results will be if no changes are made, you can decide which of the steps below will work for you.
- Match capital gains and losses. The market volatility this year gives many investors an opportunity to match capital gains and losses. Matching allows some capital gains to be taken tax free, and perhaps the rest to be taxed at the maximum rate of 20% if they are long-term capital gains (those on assets held for more than 12 months).The rules are that short-term gains and losses are netted against each other, as are long-term gains and losses. If you have a net gain in one category and a net loss in the other, they offset each other. Any net short-term gain is taxed at your ordinary income rate, and a net long-term gain is taxed at the maximum 20% rate. If you have net losses, up to $3,000 of them can be deducted against other types of income, and the rest can be carried forward to future years until used up.Review the capital gains and losses you have for the year. Then review your portfolio and look for opportunities to improve the tax picture without harming your investment strategy. Here are some ideas:
- If you already have net losses for the year, search your portfolio for gains you might want to take tax free. You can take gains up to the amount of the losses. If there are funds that for one reason or another you want to sell but haven’t done so because you would incur taxes on the gain, this is a good time to consider a sale.
- When you have net gains for the year or expect significant distributions from your funds, consider selling some of your losers in the portfolio. For example, in our long-term Core Portfolio you probably have paper losses in emerging market funds and perhaps a few others, depending on when you bought them.When you sell a fund or stock at a loss, you can deduct the loss if you wait more than 30 days to buy the investment again. You cannot take the loss until you sell the investment the second time if you don’t wait the 31 days. This “wash sale” rule allows you to sell some of your Core Portfolio to take the tax losses, then repurchase the investment after 31 days so that your long-term strategy still is intact. If you don’t want to wait 31 days or longer to repurchase the investment, you can immediately purchase a different fund in the same category. For example, you might sell Scudder Latin America and buy Price Latin America.
- Use tax strategies when rebalancing your portfolio. When your portfolio allocation differs significantly from your desired long-term goals, you should rebalance. That means selling the assets that have appreciated and are above the targets to buy more of the assets that are below the goals. That can incur costs, including capital gains taxes. So look for opportunities to match gains and losses when rebalancing your portfolio, and consider the capital gains taxes when deciding how much to rebalance the portfolio.
- Decide how to calculate mutual fund gains and losses. When you sell less than your entire position in a mutual fund, you get to choose how the basis of the shares sold is computed, and the basis determines your gain or loss. The tax law gives you four options. The tax differences between the methods can be significant.If you don’t choose a method, the first-in, first-out method is used. This can be the most disadvantageous after a bull market, because you’ll be selling the shares with the greatest gains. The average cost method is easiest to compute, since you simply average the cost of all the shares you own. The average cost, double category method involves dividing shares into short-term and long-term holdings, then figuring the average cost of each group of shares.The specific identification method can be the most advantageous. Under this method you specify which shares are sold. That usually means selling the shares with the highest tax basis so that gains are minimized or losses are maximized. But for this to work with mutual fund shares, you have to notify the fund in advance which specific shares you want sold and get written verification that those were the shares sold. Not all fund companies are good at responding to this request. To get more details on computing the basis of fund shares sold, get free IRS Publication No. 564, Mutual Fund Distributions by calling 800-TAX-FORM.
- Mutual fund distributions. Fund investors have to be careful, especially with money they invested earlier this year. Your mutual fund might be showing a loss on paper. But when the market started on the way down in July, the fund probably started selling stocks to protect gains already earned. To avoid paying taxes themselves, mutual funds are required to distribute their gains to shareholders by the end of the year. That means you could receive a sizable taxable distribution while you are showing a loss on your investment. This is especially likely to happen with funds that have a high turnover, that is, if they trade a lot during the year.This isn’t a problem in tax deferred accounts. But in a taxable account you don’t want to pay taxes to have part of your investment returned. You can call your funds and ask for estimates of the date and amount of the annual distributions. If you don’t like the numbers, consider selling the fund before the distribution, taking your capital loss, and reinvesting in a similar fund that already made its distribution.
- Avoid underpayment penalties. Many retirees have trouble getting used to the idea that they have to make quarterly estimated payments of their income taxes for the year. No one withholds taxes on capital gains, Social Security, IRA distributions, and many pensions. Penalties for underpaying estimated taxes can be stiff.
Now is a good time to see if your estimated tax payments will be enough to avoid penalties. You avoid penalties if the estimated taxes equal either 100% of last year’s taxes or 90% of the taxes due for this year. You generally are supposed to pay the estimated taxes in equal installments. So if your estimated payments have been too low, you cannot avoid penalties for earlier in the year by increasing payments now. But increasing payments now will stop additional penalties from being incurred.
You also might avoid all penalties by using the “annualization exception” to the requirement for equal estimated tax payments. You can use this exception if your income varied during the year. This might occur when you take IRA distributions irregularly or had large capital gains at some point. If the amount of your estimated payments matches the quarterly variations in income, then you might avoid penalties. Details are on Form 2210, Schedule A and its instructions.