Year-End Tax Planning for Investors

 In Investments, Taxes

For the past two years, investors have experienced extraordinarily tumultuous times. From late 2008 through early 2009, stock markets in the United States and around the world have fallen sharply. The S&P 500 Index, a leading benchmark for the U.S. stock market, lost about half of its value, for example.

As the winter of 2009 came to a close, stocks rebounded. For the remainder of last year and into early 2010, stocks enjoyed one of the strongest recoveries since the 1930s. Investors who held on recouped some of their losses, and those who timed the market successfully had sharp gains.

During the second quarter of 2010, however, stocks dived again. Debt woes in Europe and sluggish employment growth in the United States discouraged investors. As of this writing, the outlook for the balance of 2010 is uncertain.

The bottom line? Depending on your investment history, you may have a mix of gains and losses in your portfolio, short term or long term. To make savvy trades by year-end, a careful review of your holdings in taxable accounts should be done to see exactly where you stand.

Capital gain concerns
In 2010, most taxpayers owe tax at 15% on long-term capital gains. Certain low-income taxpayers have a 0% tax rate. Under current law, the 0% rate would be eliminated, and the 15% rate would move up to 20%.

The Obama Administration has proposed that the 0% and 15% tax rates be retained; only high-income taxpayers (those with income over $200,000, or $250,000 on a joint return) would owe 20% tax on long- term gains. At present, no one knows how capital gains will be taxed in 2011.

How can you proceed? The following are suggested strategies for minimizing taxes.

Take losses
If you own securities in your taxable account that are trading at levels below your purchase price, you can sell them before year-end. Such trades will provide capital losses. At year-end, those losses can offset the capital gains tax on any profits you have taken. If you have excess losses for the year, up to $3,000 can be deducted from your ordinary income. Excess losses can be carried over to future years with no time limit.

Example 1: Jim Bell takes $11,000 worth of capital gains during 2010 and $19,000 worth of capital losses. Therefore, he has a net capital loss of $8,000 for the year. Jim takes a $3,000 deduction on his 2010 tax return and carries over $5,000 of losses for use in the future.

If you wish to reinvest in the securities that you sell for a loss, beware of the wash-sale rules. Under these rules, after you sell securities at a loss, you must wait at least 31 days before repurchasing them. The capital loss won’t count if you buy them back too soon. If you are concerned about being out of the market for that time period, you are allowed to buy a similar, but not identical, security right away.

Take gains
After taking losses in taxable accounts, go over your holdings for which you have a paper profit. Do you intend to sell them soon, either for investment reasons or to raise cash? If so, you can sell them in 2010, tax free, up to the amount of your net capital losses for the year.

Example 2: Meg Clark tallies her gains and losses for 2010 in early December. She discovers that she has net capital losses of $6,000 so far. Meg intends to sell $30,000 of ABC Mutual Fund shares in early 2011 to raise money for her daughter’s college bills. At current prices, Meg would have a $5,000 gain on the sale. Meg can sell those shares in 2010, tax free, because her gains would be more than offset by her net capital losses. She’ll have a $1,000 net loss for the year, after taking $5,000 of tax-free gains, and she can deduct that $1,000 net capital loss on her 2010 tax return against her ordinary income.

What if Meg also has a $10,000 paper profit on XYZ Mutual Fund, and she expects to sell those shares in 2011? Should she sell those shares in 2010, too? If she does, the first $1,000 of gains will be offset by her net capital loss and the other $9,000 will be taxed; however, Meg will lock in the gain and owe tax at only 15%.

If Meg expects her taxable income in 2011 to be well over $200,000, taking those gains in 2010 might make sense. Even if her income will be lower, she may want to take gains this year if she fears that tax rates will increase, and she’ll owe 20% or more on a sale in 2011.

Yet another tactic: Meg could give some of her XYZ shares to her widowed mother Karen, whom Meg is helping to support. Then Karen could sell those shares in 2010. As long as Karen’s taxable income remains under $34,000 for the year, she will owe 0% tax on long-term capital gains. At year-end, our office can help you make those types of sell, hold, or giveaway decisions.