Winners and Losers
Year-end is an ideal time to review your investment portfolio to assess winners and losers and the impact of the portfolio's performance on tax planning. With the market swings we've seen this year, this is especially so for 2015, and the next month gives you ample time to plan.
Here are some key things to remember as you do, as well as potential traps through which to navigate.
Have some losers hanging around? Now may be the time jettison them, although you never want to do so just for tax purposes. Make sure first that selling them makes investment and economic sense.
But if you do decide to sell, capital losses incurred can be deducted to offset capital gains you may have recognized. Plus, an extra $3,000 of capital losses over and above gains offset can be deducted against other income for further savings.
A word of caution here. Tax rates for capital gains are at historic lows. The tax rate on long-term capital gains and qualifying dividends is 0% (that's right, ZERO) if your other taxable income is in the 10% or 15% bracket. Thus, long-term capital gains are TAX-FREE until they push you into the 25% bracket.
The point is, taking losses, if your gains are otherwise tax-exempt, could yield you limited and maybe even no tax savings if you fall into those brackets.
And while "harvesting" gains in the tax-free zone may be a good idea, bear in mind that even tax-free gains increase your adjusted gross income (AGI), which can have the effect of reducing certain itemized deductions, increasing the amount of Social Security benefits taxed, increasing your state income tax liability and other effects.
Here's another trap for the unwary. Some people desire to create losses but still want to hold a particular investment, so will sell to generate the loss and then buy the investment back. Be careful of the "wash sale" rules here.
These rules prohibit a deduction for a loss if you reacquire substantially identical securities within 30 days before or after a sale, so time things carefully. This applies to the purchase of such investments in a separate account, INCLUDING a tax-deferred account such as an IRA, so be careful!
For the philanthropically minded, here is a great tax move to consider, if you hold securities you've owned for over a year and that have appreciated in value. Consider making a donation of those investments to charity in lieu of a cash donation.
Why do that? Effectively you may receive a double tax benefit. Benefit #1, you do not have to pay tax on the investment's increase in value like you would if you sold it. Benefit #2, if you itemize, you can deduct as a charitable contribution the FULL VALUE of the security on the date of donation. Nice!
Securities that have gone down in value should not be donated, as you lose the deduction for the loss. A better strategy there is to sell, take the loss, and donate the cash.
Finally, a couple of further traps to avoid.
I have previously written about being careful when buying mutual funds at the end of the year. It is common for many funds to pay out large dividends and capital gain distributions at year's end.
The fund's value will include the value of that payout, so when buying at year-end, you are in effect purchasing the income. Then, when you receive the dividend, you are taxed on it, effectively paying tax on "income" you just purchased.
The fund's value will go down by a corresponding amount after the "record date" for the payout. To avoid the trap above, you can simply wait until after the record date to make the investment at the lower amount.
Additionally, a fairly new wrinkle in investment tax planning is the 3.8% surtax on investment income for couples with modified AGIs over $250K (over $200K for single filers). This additional tax, when applicable, needs to be considered in any planning you do if your income is in that range.
