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Managing Investment Taxes
Let the government share your tax pain.
By David Yeske, CFP
Although the passage of the 2003 tax act in May reduced the tax bite on dividend income and capital gains, investment taxes remain a reality for investors. That’s why, between now and the end of the year, it might be financially rewarding to review your investments with an eye toward further minimizing that tax bite.
One smart investment-tax move might be to buy into some of the many mutual funds that suffered large losses during the past three years of market decline. As the market recovers, these funds will be able to use their accumulated losses to help offset future capital gains and dividends they earn and distribute to shareholders—earnings you won’t have to pay taxes on.
Before following this strategy, ask whether these mutual funds are right for your portfolio. Some funds have sustained large losses and, as a result, might remain losers. Further, some types of funds that have racked up large losses—say, high-tech funds—might not be appropriate for your needs or risk tolerance.
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Never make investment decisions based solely on tax considerations. Investment decisions should be based primarily on your financial goals and the design of your investment portfolio to help accomplish those goals.
Despite three rough investment years in a row, some of you who have retired or are about to retire still might have a healthy pile of unrealized capital gains earned over a long period. You might want or need to sell some of these winners but be reluctant to do so because you dread paying the taxes.
If you must sell them, sell them. But see if you have some losing investments you could sell also to offset those gains. If you are reluctant to sell losers because you think they will rebound, sell them anyway and either wait 31 days to buy back the identical investment or in fewer than 31 days buy investments that are similar but not identical. This sidesteps the government’s 30-day “wash sale” rule, which is designed to prevent investors from wiping out their gains with quick selling and buying.
What if you have more losses than gains? First, offset what you can against gains; then, offset up to $3,000 in losses against ordinary income, such as wages. You can carry over any remaining losses to later tax years. Or—because wash rules only apply to losers—you can sell enough winners to offset the accumulated losses and then buy the winners back immediately. Strategies such as these must be taken before the end of the year.
You also can manage your investment taxes by making sure to calculate them correctly at tax time. One of the most common mistakes is not calculating basis correctly. Basis is
the cost of buying or inheriting ownership of an investment, plus adjustments. The difference between adjusted basis and what you sell the investment for is your taxable gain (or nontaxable loss).
Investors often slip up when calculating the adjustments. For example, you can add any fees and commissions you paid to buy the investment to an investment’s basis. Stock splits alter basis, and the basis of inherited investments depends on exactly when their fair market value was determined.
Mutual funds are really confusing. Investors routinely forget to add to their basis dividends and capital gains that were automatically reinvested by the mutual fund—earnings investors already have paid taxes on, assuming the reinvestments were made in previous tax years.
A better way to manage your investment taxes might be to minimize taxable gains in the first place. For example, keep income-generating investments in your tax-favored retirement or college account and growth investments in taxable accounts. You might buy individual stocks instead of mutual funds because you control when to sell the stocks, or invest in tax-free municipal bonds.
These are only a few ideas that can minimize your investment taxes—just don’t let the tax strategies overrule the investment strategies.
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