Why to do Year-End Tax Planning Now
It could be profit-able for you to make a traditional year-end tax planning move early this year. Waiting could reduce a significant tax planning benefit.
Usually I tell you to use the last quarter of the year to go through your portfolio and consider selling assets in your taxable accounts that have paper losses. Tax losses properly managed can be valuable assets. A loss in a capital asset offsets capital gains dollar for dollar. If the losses you recognized for the year exceed the gains, the excess losses up to $3,000 can be deducted from your other income. If your excess losses exceed $3,000 the excess can be carried forward to future years and used in the same way as new losses.
Because of the substantial market declines in 2008, many investors have significant paper losses. Even the stock market rally that began March 10, 2009, made only a dent in the cumulative losses from 2008.
The bear market in 2008 was broad-based. Eventually, all asset classes except treasury bonds suffered significant declines.
These paper losses can be valuable assets because of their tax benefits. Not taking advantage of them means giving up the opportunity for the government to help recover your losses and improve your long-term returns.
Suppose you suffered a 50% loss in an asset. You have not sold, because you think the asset eventually will have strong returns and is the best opportunity to rebuild your net worth.
Even so, selling to recognize the loss could be your best move. Selling allows you to book the loss as an asset. It will offset at least $3,000 of other income this year. The excess is available to shelter at least that much income each year in the future until it is exhausted or to shelter capital gains. Until the excess loss is exhausted, you will be able to make portfolio decisions in taxable accounts without considering taxes. When you have a gain and are worried about the asset’s valuation, you can take the gain knowing that it will be sheltered from taxes because of the excess carryover losses.
Deducting a capital loss against other income means you are saving ordinary income taxes instead of lower capital gains taxes. A dollar of losses deducted against ordinary income saves 35 cents in the top tax bracket, and possibly state income taxes.
Some people have to sell long-term holdings to raise cash these days, because they have lost income or value in other assets. The sales of long-term assets will result in capital gains, though the values are down from their peaks. Taking losses in other assets now will shelter the gains recognized from selling long-term assets.
One danger of recognizing tax losses is not reinvesting the sale proceeds. Do not sell if you will be tempted to spend the money or keep it in cash. Tax loss harvesting is separate from your investment policy and should not change your strategy.
Another danger is the wash-sale rule. Congress does not want you to sell an asset to take a tax loss, and then immediately repurchase that asset. If you purchase a “substantially identical asset” within 30 days of selling one at a loss, recognition of the loss is deferred. The loss is added to the tax basis of the new asset and recognized when that asset is sold.
It is easy to avoid the wash-sale rule. One way is to wait more than 30 days (at least 31 days) before repurchasing the asset. In today’s volatile markets, the price can change a lot in 31 days, so that can be risky.
The alternative is to buy an asset that is similar but not substantially identical. With mutual funds this is fairly easy. You can buy a fund with the same style or objective but not the same fund. If you sell a stock you can buy another stock in the same industry or buy an exchange-traded fund for that industry. With index funds avoiding the wash-sale rule is more difficult. The IRS has not issued much guidance. But it is likely that an index fund from one mutual fund firm is considered substantially identical to an index fund from another firm if they follow the same index. But you should be able to avoid the wash-sale rule by selling an S&P 500 Index fund and buying a Russell 3000 or Russell 1000 Index fund.
Before selling assets to recognize tax losses, check the transaction costs. There might be few or no costs when selling and buying no-load mutual funds. But transactions of other assets might generate fees and commissions. Be sure the tax losses are worth more than the cost of making the transactions. You don’t want to incur expenses that exceed the value of the losses.
If you have been following my advice, especially if you are a long-term subscriber, you don’t have the 50% losses of many investors. But you still might have some paper losses to turn into assets. Review your portfolio for losses you can take before the market recovers. The lower the price at which you sell assets, the greater will be your future deductions.
RW May 2009.
