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.