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Year-End Tax Planning for Investment Assets

By: Richard Feldman

By: Richard Feldman, CFP, AIF, MBA

Investors often make the mistake of focusing on the wrong investment metric. Typically your investment goal should be to maximize your after tax rate of return. If you are investing in a tax-deferred account taxes do not have any implications on overall investment returns but for taxable investors proper tax planning could mean an extra percentage point or two in annualized returns.

Tax-Loss Harvesting

Investors who have taxable accounts should look at their portfolio every December and see if there are any capital losses that might be realized. Selling your losers or booking tax losses now can help you offset the future tax liability created when you sell an investment at a gain. Investors in high federal and state tax brackets should try and offset short term gains if possible. Short Term capital gains are taxed at an investors ordinary income tax bracket which can be as high as 35%. Long term gains on the other hand enjoy the benefit of being taxed at a 15% tax rate. Typically short term gains and losses are netted against one another and the same thing for long term gains and losses. After the initial netting of short and long term losses the two are than netted against one another which will leave you a short term or long term gain or loss. Again it is beneficial to try and end up with a long term gain rather than short term gain due to the disparity (up to 20%) of the tax rates on short and long term gains. If you end up with a loss either short or long term, up to $3,000 of that loss can be used to offset ordinary income for tax purposes. A $3,000 loss will save you approximately $840 in taxes assuming you are in the 28% bracket.

Share Identification

Tax loss harvesting might also be used for an investment that has different tax basis or lots. Individuals might have purchased securities at different times and depending on the price may have a gain in one or a loss in the other. In situations like this you can use a method called lot identification or versus purchase. Typically this is done by telling your financial advisor or broker that you would like to sell a specific tax lot rather than the usual accounting method of average cost. Typically your confirmation will show that the shares were sold versus the specific lot you had purchased on a certain date.

Wash Sale Rule

Make sure your tax-loss selling conforms with IRS guidelines known as the Wash Sale Rule which will disallow a loss deduction when you recover your market position in a security within a short time before or after the sale. Under the Wash-Sale Rule, a loss deduction will be disallowed if within 30 days of the sale you buy substantially identical securities, or a put or call option on such securities. The actual wash-sale period is 30 days before to 30 days after the date of the sale (61-day period). The end of a taxable year during the 61-day period still applies the wash-sale rule, and the loss will be denied. For example, selling a security on December 25th of 2004 and re-purchasing the same identical security on January 4, of 2005 will disallow a loss.

Carry Forwards

Assess your gains and losses. Individuals should look at Schedule D of their tax return in order to determine if they have any carryforwards that could offset any potential capital gains distributions or sales that might create a gain. Individuals who have a loss carryforward should still harvest any losses if possible. These losses may offset any future gains that are made in the stock market or real estate.

Year End Capital Gains Distributions

Mutual fund investors need to be careful when purchasing funds at the end of the year. Mutual funds by law are a pass through entity, which means the tax liabilities they incur from investments pass through the fund and on to the shareholder. Funds must pay shareholders 98 percent of the dividends and capital gains. The Investment Company Institute, a mutual fund trade group, estimates that capital gains are going to be roughly in line with or somewhat higher than last year. Long term capital gains distributions from mutual funds were $14 billion in 2003 and $16 billion in 2002. Capital gains distributions over the past two years were mitigated by losses incurred inside mutual funds due to the stock market declines from 2000 to 2002. Stock market gains in 2003 and currently in 2004 have caused most of those carryforwards to be used up and should now look to have some sort of distribution in December. Asset classes that should have the highest distributions due to their out performance is small cap stocks, real estate, and natural resource funds. Remember if you own the fund when it makes a distribution you will have a tax liability associated with that distribution even if you only owned the fund a day before the distribution. Make sure you check the fund companys estimates of dividends, short term-gains, and long-term gains before you buy them at year end in a taxable account.

Gift Appreciated Assets

Thanks to President Bush it is more appealing than ever to gift appreciated assets. Giving highly appreciated assets to someone in a lower tax bracket or charity can effectively reduce or eliminate taxes entirely and remove the asset from your estate. Due to the new tax laws, if you gift a highly appreciated security to an individual in the 10% or 15% bracket they will only pay 5% capital gains taxes on the appreciation. Under current tax laws if the donee keeps the asset until 2008 and is still in the 10% or 15% tax bracket their will be no taxes due.

Summary

The biggest drag on investment performance is taxes. For taxable investors, proper year end tax planning will allow you to keep more of your investment return and pay less to the government. After all you cant spend pre-tax earnings it is the after-tax funds that you need to focus on.