The end of November to early December is a good time to evaluate your investment portfolios and make decisions that can reduce or increase your taxes for the current year. A study by Fidelity Investments found that 67% of families do not take advantage of offsetting capital gains and capital losses to lower their taxes. Unless you wish to be part of that group; read on. There's still 2 weeks left to act.
The first step in this process is to prepare, or have your accountant prepare, your current year projected tax return based on your income and deductions for the first 10-11 months and then project 1-2 more month’s of income and deductions. After you apply all the applicable credits, you will have a good idea as to your taxable income, tax due, and tax bracket for 2006.
If your income is low enough so that your marginal tax rate is 0%, then consider selling stocks or mutual funds that have a gain as the marginal tax rate on the gain will start at 0% and end at no more than 10%-15% depending on whether the gains are long term or short term. Even if you are in the highest income bracket of 35%, your maximum capital gains rate will only be 20% for selling securities with long-term capital gains.
You need to check your realized gains from stocks or bonds sold during the year, and - if you are a mutual fund investor there may be some capital gains distributions paid into your account prior to the end of the year. If so, you might want to sell some shares of stock or other mutual funds with losses to offset those gains. Your financial advisor will know the estimated distributions from the mutual funds and can plan accordingly and provide your tax preparer the amounts. However, if you really like a stock or mutual fund, do not sell it at a loss unless you are willing to wait the required 31 days before buying the stock or fund back so as not to violate the IRS "Wash Sale" rules. Tax planning itself should not direct all investment decisions.
A good rule of thumb is to take short-term losses only against short-term gains, and long-term losses against long term gains. Any short-term losses not offset by short-term gains will be applied against long-term gains – and this converts the long-term gain into a short-term gain, thus losing the tax advantage of a lower long-term gain tax rate.
Finally, when selling less than your full position in a security you can decide how much gain or loss to take based on choosing the purchase date, cost basis, and amount of the shares sold. I hope this helps you save and plan better for these important year-end decisions in your taxable accounts.
Peter S. Cummings, Jr., CPA