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Tax Planning Strategies for Taxable Investors

By: Richard Feldman

By: Richard Feldman, MBA, CFP®, AIF®

The equity markets have snapped back aggressively from the bottom of the market in March 2009 causing investors to utilize capital loss carry forwards they may have established during the market downturn. This may mean that investors, on a going forward basis, might once again be looking at paying capital gains in the future and may need to look at ways to be more tax efficient in their taxable accounts.

Tax-Loss Harvesting

Investors who have taxable accounts should look at their portfolio at least quarterly 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 rate 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 as are 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 with either 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 a short term gain due to the disparity (up to 20%) of the tax rates on short and long term gains not including state taxes. If you end up with a loss, either short or long term, $3,000 of that loss can be used to offset ordinary income. A $3,000 loss will save you approximately $840 in taxes assuming you are in the 28% bracket.

With the advent of Exchange Traded Funds, tax loss harvesting has become much easier. If you wanted to take a loss in any particular asset class you could sell the mutual fund and replace it with the corresponding exchange traded fund for 31 days and then move the assets back. This will allow you to maintain the integrity of your asset class exposure.

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 and a loss in the other. In situations like this you can use a method called lot identification or “versus purchase. This can be done by telling your financial advisor or broker that you would like to sell a specific tax lot rather than using the usual accounting method of average cost. Typically, your trade confirmation will show that the shares were sold versus the specific lot you had purchased on a certain date. This strategy is more commonly used with common stock than with mutual funds.

Wash Sale Rule

Make sure your tax-loss selling conforms with the IRS guideline 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 to the wash-sale rule, and the loss will be denied. For example, selling a security on December 25th of 2010 and re-purchasing the same identical security on January 4th of 2011 will disallow the 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 carry forwards that could offset any potential capital gains distributions or sales that might create a gain. Individuals who have a loss carry forward should still harvest any losses if possible. These losses may offset any future gains that are made in the stock market or in real estate investments.

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% of the dividends and capital gains. 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.

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. I can attest that tax loss harvesting has become easier due to the increased number of exchange traded funds (ETFs). After spending two weeks implementing the above strategies I was amazed at how much easier it has become to maintain the integrity of your investment portfolio by using ETFs for the proceeds of trades made to book tax losses.