Want to ease your tax burden? We mean legally, of course; we're sure you don't want to deny Uncle Sam his due. But you probably don't want to pay more than your fair share, either. Well, the time to rearrange your portfolio for optimal tax savings is now, before 2001 is history. Here are a few tips that you might want to consider.
Taxable gains and losses
See if your investment allocations (the balance among stocks, bonds, mutual funds, cash, etc.) are consistent with your original plans. Significant stock market run-ups or downturns can substantially change your intended weighting in the various asset classes. If your balance meets with your current plans, great! If it doesn't, you might want to review your portfolio, sell some assets, and redeploy the cash elsewhere.
For investments in a tax-advantaged account -- such as an IRA, 401(k), SEP-IRA, or 403(b) -- you won't realize any tax consequences if you decide to sell an investment, regardless of whether you sell at a profit or loss. But, for investments that are not in a tax-deferred account, your decision of what and when to sell has significant tax consequences.
Review your portfolio to see if you already have realized gains (from investments you sold at a profit) over the past year. If so, you might want to sell something (perhaps a deflated stock) and take some losses to offset those gains. Note: If you want to repurchase some of those shares that you're selling for a loss, make sure that you don't run afoul of the wash sale rules.
If you're a mutual fund investor, you'll likely be receiving capital gains distributions from your various funds at the end of the year, and those capital gain distributions also qualify as gains that you can offset with losses.
Remember that you'll receive a preferred tax rate for your long-term capital gains (gains on investments held for more than one year), but you'll pay taxes at your "ordinary" rate on short-term gains. You really don't want to disturb any of your long-term gains if you can help it. To protect the preferred tax rate you'll receive with these gains, be careful when looking at what assets to sell and the losses that you might want to take. It's very possible that short-term losses you realize will affect your long-term gains -- not an ideal situation.
So, while you're going through this exercise, make sure to categorize your gains and losses by short-term and long-term components. When possible, try to take short-term losses only against short-term gains. Whenever possible and prudent, allow your long-term gains to be taxed at the preferred tax rate rather than offsetting them with short-term (or even long-term) losses. As a rule of thumb, you want to keep your long-term gains intact and use any losses (either short- or long-term) to offset any short-term gains.
Because of the requirements to segregate your profits and losses by short-term and long-term components on the tax return, this can get very tricky. But it's certainly something to consider when deciding which investments to sell. For more information, read Netting Out Capital Gains and Losses on Schedule D.
Selling investments purchased over time
You might find that you want to liquidate an investment that you have purchased and/or accumulated over months (or even years). You might still love the investment, and it might still make sense for you to hold it for the long term; you simply want to sell a portion of that investment. If you'll be selling less than your entire position in the investment, then it's usually best to sell the shares that will affect your taxes the least. Those will be the shares with the highest cost basis.
Generally, those would be the shares that you've held for the shortest period of time. By selling the shares with the highest basis, you'll reduce your exposure to that specific investment, generate cash to be used as you see fit, and minimize your tax liability on the sale.
If the shares you want to sell aren't the first ones you acquired, you'll have to do some fancy footwork to "specify" the shares you want to sell. When you're dealing with most stock and mutual fund investments, you're stuck with the FIFO (first in, first out) method of accounting for that investment. But, you can overcome the use of the FIFO requirement if you can actually "specify" the shares that you wish to sell. The tax issues regarding "specifying" shares can be a bit complex, so if you're going to use this gambit, make sure that you understand what must be done. If you want to learn more, read Identifying Stock Sold for Tax Purposes.
Catch up your retirement plan contributions
As you know, there are maximum limits to employer-sponsored retirement plan contributions each year. Generally, your contributions must be made throughout the year, but some plans allow for "catch-up" contributions in December if your contribution level is less than the maximum allowed? Using your December bonus to add to your plan (when allowed) might be a good way to dodge some current taxes. If your employer matches some of your catch-up contributions, you're in even better shape. Not all plans allow for this "catch-up" provision, so check with human resources or your company's benefits administrator. If you don't have a retirement plan at work, consider a tax-deductible traditional IRA.
Superlong-term gain rules and deemed sale election
The Taxpayer Relief Act of 1997 included provisions lowering the tax rate on gains from the sale of stock or mutual funds (and certain other property) held more than five years. The "normal" 10% long-term capital gain rate (for those paying income taxes at or below the 15% rate) drops to 8%. And the normal 20% long-term capital gain rate (for those paying income taxes at or above the 28% rate) drops to 18%.
One of the "kickers" in the new law is that the stock must generally be purchased after Jan. 1, 2001, and held for at least five years to qualify for the new superlong-term gains rates. You'll note that I said "generally," because the new 8% superlong-term rate will apply as long as the shares have been held for five years -- regardless of when they were originally purchased.
The law says that if you hold a stock on Jan. 2, 2001, you can elect to deem it "sold" effective on that date and then deem it "repurchased" on the same date to begin your five-year holding period on Jan. 2, 2001. You don't actually have to sell and repurchase the shares and incur brokerage commissions on the actions. You simply "deem" the shares sold and repurchased at their fair market value on Jan. 2, 2001.
If you deem the shares sold and repurchased, any gain will be treated as a taxable capital gain, but any loss will be ignored for tax purposes -- in 2001 and in future years. The loss will be completely lost, with no basis adjustment for the future and no tax benefit for that loss.
The beauty of this election is that it doesn't have to be made until you file your 2001 tax return (sometime in the spring of 2002). So it's very possible that you can "deem" some shares sold and create capital gains that you can use to offset some of your capital losses. This might help you right now, while getting those shares that you "deemed" sold under the new superlong-term gain holding period rules, possibly reducing your tax bite on any future gains. For more information, read Superlong-Term Capital Gain Rates and Strategies.
Worthless stock
How about those stubs you own that have completely fallen off the radar screen? Perhaps the company is in bankruptcy, or de-listed, or worse! Worthless stock could generate a capital loss for you. But "worthless" is a technical term from a tax standpoint. It means more than just the bottom dropping out of the price of the stock or a suspension of trading of that stock. There are some tricks that you might be able to use to get these shares sold before the end of the year, so you don't have to fight over the term "worthless" with Uncle Sammy. But make sure that you understand the rules, which are explained in Worthless Stock.
Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.
