Year-End Tax Planning For Investors

December 2007

The tax code is replete with provisions relating to investments. Here are some tax-saving tactics to consider before year end:

Track your trades. Start by going over all of your securities trades so far this year. Aim to conclude 2007 with capital losses that exceed capital gains by at least $3,000.

Why should this be your goal? Because a net capital loss up to $3,000 can be deducted from your ordinary income. If you're in a 35% tax bracket, for example, a $3,000 capital loss saves you $1,050 - 35% of $3,000. Your total tax savings may be even greater when you count state and local income taxes. Suppose you count all your trades so far in 2007 and discover you have a $5,000 net capital gain. If you don't take any action, you'll owe $750 to $1,750 to the IRS. The exact amount will depend on how your trades divide between long-term gains (taxed at 15%) and short-term gains (up to 35%).

Take your losses. Starting with your $5,000 year-to-date gain, you can sell securities by year end, realizing $8,000 worth of losses. Now, you have a $3,000 net loss and a tax deduction rather than a tax obligation.

What if your net capital loss is greater than $3,000? Any excess loss can be carried forward to future years, when it can offset future capital gains. If you have no gains to offset, loss carry-forwards may be deducted, up to $3,000 per year.

Factor in mutual funds. When you calculate your 2007 gains and losses, be sure to include any capital gains distributions from mutual funds. Mutual funds are required to distribute and net trading profits to shareholders. If you hold the fund in a taxable account, such distributions are taxable income, even if you choose to invest them in a fund.

In the example above, it was assumed you had $5,000 worth of net capital gains for the year, before making any year-end moves. If you also received $2,000 worth of capital gains distributions from mutual funds, your net gain for the year would go up to $7,000. In that case, you'd need to realize $10,000 worth of losses to end the year with a $3,000 net capital loss.

Buy later, not sooner. Call your mutual fund companies to find out if such distributions are planned for December. Avoid investing in any mutual funds just before a scheduled capital gains distribution. You'll get some of your own money back right away … and owe tax on that return of your capital.

For example, suppose you invest $25,000 in XYZ Mutual Fund on December 6, when the fund trades at $20 per share. You'd acquire $1,250 shares: $25,000 divided by $20. Suppose that XYZ makes a $5-per-share capital gains distribution on December 15, representing its 2007 net capital gains. You'd receive a $6,250 distribution - $5 per share on your 1,250 shares. If you hold the fund in a taxable account rather than in a tax-deferred or tax-free retirement plan, you'd owe tax on that $6,250 distribution even though you really haven't enjoyed any gains.

At the same time, the net asset value (and the trading price) of the fund would drop from $25 to $20 after the fund makes its $5 distribution. You'd be better off waiting until after the distribution to buy the fund because you'll probably be buying at a lower price and you'll avoid the tax liability. Check with the mutual fund you're considering before investing around year end. Find out the "record date" of the fund and buy on the next day (ex-dividend date") or later because the fund's share price will drop after the distribution.

Buy sooner, not later. The timing of the ex-dividend date also can make a difference to fund sellers. That will be true if you'll be selling for a long-term capital gain and the distribution will include short-term capital gains as well as nonqualified dividends.

Suppose you invested many years ago in XYZ Precious Metals Fund. This fund has performed well over the years, and precious metals are above your target for asset allocation. You decide to sell shares to rebalance your portfolio. Say that XYZ will make a year-end distribution that will include net long-term gains, net short-term gains, and dividends that do not qualify for the bargain 15% rate on stock dividends. The total distribution will be $5 per share, of which $3 will be short-term gains and non-qualified dividends. After the $5-per-share distribution, the price of XYZ drops from $25 to $20 per share.

If you hold onto your shares until after you receive that distribution, you will pick up $5 per share in taxable income, including $3 per share taxed as short-term gains and nonqualified dividends, where the federal tax rate is as high as 35%. Instead, you could sell before the distribution, when the fund is still trading at $25. Assuming you've held all the shares for more than one year, all of your gain will qualify as long-term, with federal tax rates at 15% or lower.

Boost your basis. When you do your year-end tax planning, you might discover you have a large realized loss so far for 2007. In this situation, you may be able to take capital gains, tax free.

Suppose, for example, you have $10,000 worth of realized net capital losses so far this year. You can generate $7,000 worth of capital gains by year end and offset that amount with your capital losses. You can then deduct the remaining $3,000 net loss fro your ordinary income.

Make lemonade from a lemon. If you invested in a business that failed in 2007, you can take a capital loss this year. To take the loss, your holding in the failed venture must be absolutely worthless. However, it may be hard to show that a business has no value at all.

To deal with this problem, realize your capital loss by selling your interest in the business to an unrelated party for a nominal amount. For example, you might sell your interest in the failed company to a neighbor for $1. As long as you make the sale by December 31, you can claim a capital loss for 2007.

Swap shrewdly. Exchange-traded funds (ETFs) can play a role in tax-loss harvesting strategies. When you take a loss on a security, the wash-sale rules prohibit buying back the same stock or fund within 30 days, though, you might miss out on a sharp upward move in the stock or fund you just sold.

One solution to this problem is to buy an ETF that correlates closely with the stock or fund you have sold. Say you take a loss on a bank stock that has been hurt by subprime mortgage concerns. You can immediately buy an ETF that tracks an index of bank stocks, such as the KBW Bank ETF. Buying a highly-correlated ETF won't prevent you from reporting a capital loss on the bank loss you sold. Then, if that bank stock runs up, chances are the bank ETF also will gain ground. After 31 days you can sell the ETF and go back into your original stock, if you wish, without forfeiting the capital loss you previously realized.

Cash in on your kids. If you're planning to sell appreciated securities to pay for college, there's a smarter move you can make. Give those securities to your children. Parents can give up to $24,000 worth of assets this year to each child without triggering any gift tax. After the securities have been transferred, the child can sell them before year end. As long as the child is at least 18 years old, tax will probably be due at a 5% rate on long-term capital gains, rather than your 15% rate. If you wait until next year, you might be out of luck. New Kiddie Tax rules will make it much more difficult to save taxes by having students under age 24 sell appreciated securities.

Win the waiting game. In 2008, dividend income and long-term capital gains may be tax free. That will be the case for taxpayers with less than about $32,500 in taxable income. For married couples filing joint returns, the 0% tax bracket will go up to around $65,000 in taxable income.

As mentioned, new Kiddie Tax rules will make it difficult for students under age 24 to use this 0% tax bracket. However, students over 23, young workers just beginning their careers, and retirees may have incomes low enough to qualify for the 0% tax rate in 2008. If you (or a relative) expect to qualify for the 0% tax rate in 2008, don't take long-term capital gains at year end. Wait until January to sell appreciated securities, when profits may be tax free.

Tame the AMT. Suppose you are locked into the AMT for 2007. Say you invested $25,000 in a speculative stock early this year and that stock has shot up to $80,000. You're afraid that this stock might give back all those gains so you'd like to sell. Ordinarily, you'd owe tax at rates up to 35% on positions held for one year or less.

With the AMT, while your taxable income is higher, tax rates are lower: 26% (up to $175,000 in AMT income) and 28%. Therefore, you can take those short-term gains by year end and pay tax at the relatively low AMT rates.

Defer and conquer. In another scenario, the AMT might cause you to defer long-term capital gains. When you take long-term capital gains, your income increases and, at certain income levels, the "AMT exemption" is phased out. Roughly, between $150,000 and $400,000 on a joint return you're paying tax at a higher rate because you're losing the AMT exemption. The AMT can effectively raise the tax on long-term gains from 15% all the way up to 21%, in some circumstances.

It might be possible to take some gains in December and some next January. Spreading the gain over two tax years may eliminate or reduce the extra tax resulting from the AMT.

. . . or act now. On the other hand, taxpayers at certain income levels will find that speading taxable gains over two years might be a trap. You might be in a phaseout range both years, paying tax at a relatively high rate. You might actually pay tax at a lower rate if you take a large gain this year.

The bottom line is that there is no simple way to deal with the AMT. Check with our office before taking a substantial capital gain at year end.

(Information provided courtesy of the AICPA)

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