Investors usually wait until at least November for year-end tax planning. But given the volatility of recent market, financial planners say it should be a year-round effort.
Stock market losses "should motivate everybody to look at their portfolios," said Nancy Dunnan, author of the Dun & Bradstreet Guide to Financial Planning.
The first thing you should do is take a deep breath.
Examine your investments. Determine if youre really enjoying the gains or suffering the losses that you think you are. The answer to this question will go a long way toward determining your best course of action.
Obviously, if all your money is in tax-deferred accounts, such as a company-sponsored 401(k) plan or individual retirement accounts, you dont have to worry about taxes--yet.
And many people who truly have long-term time horizons may argue that theres no reason to make any portfolio changes simply because of one years losses--especially if youre happy with your investments prospects.
In general, though, financial planners say stock and mutual fund investors would do well to focus on three things: capitalizing on losses, minimizing taxes and preserving any gains accrued this year. It could be well worth any commissions you spend in the process.
Capitalize on Losses:
At the least, financial planners say, investors should think about locking in their losses immediately. Thats because the IRS will allow you to profit, in a way, from them.
Lets say you invested $10,000 in March in the Go-Go Hot Sector Fund. Since that time, the fund has plunged 89.1%.
Obviously, the bad news is that youve lost $8,910 on your original investment. The good news: The IRS will allow you to use those losses, dollar-for-dollar, to offset capital gains in other parts of your portfolio. All you have to do is sell out of the fund to take advantage of this provision.
Its like picking nickels off the street, said Denver financial planner Dick Wagner. Were advising our clients to start looking at harvesting those tax losses.
What if youre afraid to sell? For instance, what if you think one of your funds will roar back?
Though the IRS will not let you sell an investment and immediately reinvest in it--you must, according to the wash sales rule, wait at least 30 days or risk losing the tax benefit--you are allowed to invest in a similar asset as long as it is not substantially identical to the original one.
Say you own a fund that invests in small U.S. growth companies. It happens to be down 20% this year. If you think that small-cap growth investing is still the way to go, says Columbus, Ohio, financial planner Peggy Ruhlin, then sell that fund, lock in those losses and roll into a competing fund companys small-cap growth portfolio.
Its like having your cake and eating it too.
And given the sheer number of mutual funds that are available to retail investors today, its quite easy to find two funds that invest in principally the same companies, said Sheldon Jacobs, editor of the No-Load Fund Investor newsletter.
Stock Investors Can Do the Same
A word of warning: Dont try to be cute with the IRS. Jumping out of a funds Class A shares and into its Class B shares wont fly, tax accountants say. And its unclear if the IRS will allow investors to move from one companys index fund--passively managed portfolios that simply mirror a stock index--into a competing firms index fund.
Still, with funds, its a little easier than individual stocks, said Gerald Perritt, editor of the Mutual Fund Letter in Largo, Fla.
But stock investors can do virtually the same thing.
Say you want to lock in losses on your Halliburton stock. But you think oil services stocks are ready to rebound. Theres nothing preventing you from selling your Halliburton stock and immediately investing in Schlumberger, a competing oil field services firm. (Obviously, you should do your homework. Before you take such action, make sure youre comfortable selling the stock you own and buying the competing firms shares.)
Some of you may be wondering: Why should I even think about locking in losses? All my mutual funds are losing money this year. I have no capital gains to offset my losses.
This is a point that confuses many investors, said Barbara Raasch, partner in Ernst & Youngs personal financial planning group in New York. For starters, just because your funds have lost money in recent months doesnt mean youve actually lost money.
For instance, lets say you bought your fund 18 months ago at a net asset value per share of $10. By the second quarter of last year, the funds NAV rose to $15. But in the third quarter, it dropped back down to $12. Though the fund fell 20% in the third quarter, youd still record a profit from the investment if you sold.
Even if your fund is losing you money, it may still expose you to capital gains. Some funds are sitting on realized gains that they wont distribute to investors until later. That means that even if you bought your shares after the funds shares started to slide, you may still receive distributions for which you would owe taxes.
Conversely, investors in funds that have done tremendously well over the years may not be sitting on as much of a taxable gain as they think. Why? Because, with the possible exception of index fund investors, mutual fund shareholders have been paying taxes each year on any distributed gains. So when you finally sell, your untaxed gains may be minor.
Before you go about tax-loss selling, then, make absolutely sure you really have the loss or gain you think you do. Taking advantage of investment losses can get complicated, so you may want to have an accountant help you through it.
Short-Term vs. Long-Term
Heres the complicating factor: The federal government taxes capital gains at two different rates. Profits on investments held less than 12 months are taxed at ordinary income tax rates. These are referred to as short-term gains. And profits on investments held for more than 12 months are considered long-term gains and are taxed at a maximum of 20%.
You want to be real careful here, said Raasch, adding that you dont want to waste precious losses. You almost have to apply opposite logic to best utilize your losses.
Raasch notes that normally investors prefer long-term gains because they are taxed at a substantially lower rate than short-term profits. But when it comes to losses, Raasch said, investors should favor those of the short-term variety.
In other words, you should think about locking in losses on funds or stocks youve held for less than 12 months before locking in losses on investments held for longer periods.
Why? The IRS makes investors line up particular losses with corresponding gains. For instance, your short-term losses will first be used to offset short-term gains, and any excess losses will then apply to long-term gains. Similarly, long-term losses will be used to offset long-term gains.
Once youve offset all your gains, you can apply losses of up to $3,000 a year toward your ordinary income. (Thus, investors who dont have gains to report can still consider tax-loss selling.)
Get rid of [offset] your short-term gains first, Raasch said. That way, if you have gains left over, theyll be long-term gains, taxed at only 20%.
Aside from offsetting capital gains, there are other ways for investors to minimize taxes.
Indeed, how you choose to sell your funds can, in some cases, cut your tax bill by as much as 60%, said Rande Spiegelman, manager of KPMG Peat Marwicks personal financial planning services in San Francisco.
Lets say you want to sell out of a losing fund, but not entirely. Lets say you only want to unload half the shares you own. Which shares do you sell? Those you bought first? Those you bought last? An average of the two?
When making a partial sale, the IRS gives fund investors a choice of four options to determine which shares they intend to sell. Its not the shares that matter so much as the original price of the shares being sold.
The methods are: first in, first out (FIFO), in which you sell your shares in the order you purchased them; average cost single category, in which you average out the price of all your shares; average cost double category, in which you separate your shares into two groups, long-term holdings and short-term holdings, then calculate each groups average purchase price; and specific identification, in which you select, for tax purposes, which shares you intend to sell.
Which option you choose can make a big difference, Spiegelman said. Here, you should really consult an accountant.
Though FIFO works against investors in rising markets, the strategy will generally be the best option in a period of declining share values, Spiegelman said.
For instance, imagine you bought 10 shares of a fund at $20 a share. Six months later, you bought another 10 shares at $21. And six months after that, you bought another 10 at $22.
Then the market begins to tank. So, too, does your mutual fund. All of a sudden, your funds NAV per share falls to $20 and you want to sell a portion of your holdings.
Good Records Are Vital
With FIFO, you can sell the first 10 shares you bought at $20. That way, you wont incur capital gains--as you would had you averaged out your investment costs.
Spiegelman recommends using this method for selling funds that have fallen precipitously over a long stretch of time.
Selective identification has its advantages in rising markets. It can also be used by investors to lock in losses for funds that have made money.
For instance, if you bought 10 shares of a fund at $20 a share, another 10 at $25 and 10 more at $30, and then the funds net asset value per share drops to $29, you can actually lock in the losses for those 10 shares you bought at $30--despite the fact that youve still made money, overall, through this fund.
Be warned: Both FIFO and selective identification require good record-keeping on your part. When using selective identification, for instance, investors must notify their fund companies in writing, indicating which shares they wish to sell. Confirmation of the notification must also be kept for IRS reporting.
If you were fortunate enough to make money in stocks recently, but you dont want to take those gains this tax year, you may want to think about locking in those gains.
One way to do so, without actually selling a stock and triggering taxes, is through the use of collars. Lets say you own a winning stock and want to lock in the gains. You can do this by simultaneously buying a put option and selling a call option on that stock with similar strike prices--the price at which the options can be exercised.
A put is an option that gives you the right to sell a certain number of shares of the stock at a preset price by a certain date. A call gives you the right to buy a certain number of shares of a stock at a preset price, by a certain date.
Through puts and calls with a similar strike price, you in effect predetermine a range for how much more you can gain or lose on that stock in a set period.Investors need to be careful when using collars, though, because the IRS may object if you set the collar too tightly around the stocks price.
Spiegelman, for instance, says a 10% or so band on either side of the price is probably safe. For instance, if your stock is selling at $100 per share, you might consider buying a put at $90 and selling a call at $110.
On this and all the issues discussed in this column, dont neglect to consult a professional.Copyright © 2014, Los Angeles Times