Stocks
performed reasonably well for much of 2011 but fell
precipitously after the downgrading of the United
States credit rating. As of this writing, the investment
outlook for 2011 is quite uncertain. Despite that
fact, there are things you can do with your portfolio
by year-end to reduce the tax you'll owe for 2011.
Start by reviewing
Schedule D of the federal income tax return you filed
for 2010. See if you are carrying over any net capital
losses from previous years. The next step is to tally
your trading activity for 2011 so far. You can determine
if you are in a net capital gain or loss position
for the year to date.
Example 1:
Jane Collins is carrying over $10,000 worth of net
capital losses from prior years. So far this year,
her security trades have generated a net gain of $18,000.
If Jane takes no further action, she can use her loss
carryover to offset part of this year's gain and end
up with an $8,000 net capital gain. If those gains
are all long term, meaning that Jane held the securities
for more than a year before selling them, she will
owe $1,200 in tax, at a 15% rate, assuming that Jane
owes the maximum tax rate on long-term capital gains.
Learning to Love
Losers
To reduce her tax
bill, Jane can take capital losses before year-end.
If she takes $8,000 worth of losses, for example,
Jane will have a $10,000 net gain for 2011: her previous
$18,000 net gain minus $8,000 in year-end losses.
With a $10,000 net gain for 2011 and a $10,000 loss
carryover from her 2010 tax return, Jane will have
neither net gains nor net losses.
Therefore, she'll
owe no tax on her trades for her 2011 tax return.
If Jane takes $11,000 worth of losses by year end,
she will have a $3,000 net capital loss to report
for 2011. That amount is the largest capital loss
you can deduct on your tax return each year.
If Jane is in a 25%
federal income tax bracket and reports a $3,000 capital
loss, she will save $750 in tax -- 25% of $3,000.
On the other hand, if Jane takes no year-end losses
she will owe $1,200 in tax, as explained in example
1. Altogether, Jane improves her tax position by $1,950
(going from a $1,200 tax obligation to a $750 tax
savings) by taking $11,000 in capital losses by year
end. Reducing her adjusted gross income (AGI) by going
from a net capital gain to a net loss also might help
her use other tax deductions and tax credits.
When you do your year-end
tax planning for capital gains and losses, remember
to include capital gains distributions from mutual
funds. If you hold the funds in a taxable account,
you'll owe tax on those distributions, even if you
reinvest the distributions in the same fund. Your
fund's website should post 2011 distribution information
by November or December. If you have 1,000 shares
of ABC Fund, for instance, and the fund announces
a $1 per share capital gains distribution, you'll
know that you'll be reporting $1,000 of taxable gains.
Reinvestment
Rules
If you sell securities
to generate capital losses, you'll receive cash. You
may want to maintain the shape of your portfolio;
however, you can't immediately purchase the same security
you've just sold. Such a transaction, called a "wash
sale," disallows your capital loss.
Three ways to keep
your portfolio on track yet avoid a wash sale include
the following:
1.
Double up. To use this tactic, you must begin
the process before the end of November. You buy an
additional amount of the securities you wish to sell,
wait more than 30 days, and then sell the original
holding for a capital loss.
Example 2:
Ken Larsen bought 200 shares of XYZ Bank Corp. a
few years ago, at $80 a share. XYZ now trades at
$50 a share. On November 23, 2011, Ken buys another
200 shares of XYZ. On December 27, 2011, which is
more than 30 days later, Ken instructs his broker
to sell the original 200 shares at $50 apiece. He
takes a capital loss of $30 a share, or $6,000,
on the 200 shares.
With
this tactic, Ken avoids a wash sale. He also maintains
his position in XYZ Bank Corp., which Ken believes
is undervalued at $50 a share. As you can see, Ken
has invested another $10,000 in XYZ, so he stands
to gain more if the stock price moves up or lose more
if it keeps falling while he is holding the additional
200 shares. If this approach appeals to you, double-up
before the end of November so you can wait more than
30 days and still claim a capital loss for 2011 with
a year-end sale.
2. Hold your
cash. You also can avoid a wash sale by holding
onto the sales proceeds for more than 30 days before
reinvesting. If Ken sells his original lot of XYZ
Bank Corp. for a $6,000 capital loss on November
23, he can park the money he receives in a bank
or brokerage liquid account for more than 30 days.
Then Ken can repurchase 200 shares of XYZ without
losing his capital loss. In this scenario, Ken takes
the risk that the trading price of XYZ will move
sharply higher while he sits on the sidelines.
3. Buy something
similar but not identical. If Ken does not want
to be out of the market for more than a month, he
can take the $10,000 he receives for selling 200
shares of XYZ on November 23 and immediately buy
another bank stock or a fund that holds many bank
stocks. Such investments may rise or fall with the
industry outlook, just as XYZ would, but they won't
jeopardize a capital loss. After more than 30 days,
Ken can repurchase XYZ if he wishes. In the interim,
Ken takes the risk that the replacement holding
might not perform as well as XYZ.
