Year End Tax Strategies

As we approach the end of the year, now is a good time to review your investment portfolio. The reasons are two-fold: First, you want to make sure that your allocations to various asset classes and specific securities are still appropriate for your investment strategy. And second, you still have time to realize potentially significant tax savings by harvesting paper losses in your taxable accounts. 

Detecting Drift

When you established your particular investment strategy, you and your advisor probably determined an ideal mix of stocks, bonds, and other investments to help you achieve your specific financial goals. As markets move, however, those allocations can drift – sometimes radically – away from your targets. 

For example, your ideal allocation to stocks may be 60 percent of your investment portfolio, but due to the strength of stocks this year, you may find that stocks now account for a far higher percentage than your target. As counter-intuitive as it may seem, you should aim to take profits and bring your stock allocation back to your ideal level. Doing so will help you lock in gains and will also keep your investments in line with your risk profile. Ideally, you should do this type of rebalancing at least once a year.

Considering Taxes

When rebalancing your portfolio, you need to consider all of your investment accounts, including your taxable accounts, your tax-advantaged plans, and any other savings and investment vehicles you may have.

Realizing profits in vehicles such as 401(k) plans or an Individual Retirement Account does not bring major tax implications into play since taxes on gains are deferred until retirement or when they are withdrawn – and in the case of a Roth IRA, there are no taxes on investment gains. Qualified withdrawals from traditional IRA’s and  401(k) plans taken prior to age 59 ½, may be subject to an additional 10% federal tax penalty and possibly state income taxes. Qualified distributions of earnings from a Roth IRA are tax-exempt after five years from the contribution date and after age 59 ½. Earnings taken prior to age 59 ½, may be subject to a 10% federal tax penalty and possibly state income taxes. But in your taxable accounts, taxes are a significant factor to consider in your investment decisions.

If you sell a security for a capital gain in a taxable account, you may want to offset that gain as much as possible by realizing losses in your unprofitable positions and deducting these from your long- or short-term capital gains. As you go about matching winners with losers, however, keep in mind the “wash-sale rule,” which prohibits tax deductions if you buy the same – or substantially similar – securities 30 calendar days before or after the loss sale. 

For example, if you’re holding stock “ABC” at a price less than what you paid for it, you might sell the stock to realize the loss. But then, some good news comes out and you buy it back two weeks later. In this instance, you will not be allowed to take the loss in the tax year in which you made the sale, although as consolation, your basis in the stock is stepped-up by the amount you paid for it the second time around.

Don’t Forget Bonds

The opportunity to achieve tax savings is not confined to your stock holdings. Many wealthy investors also hold substantial assets in municipal bonds for their tax advantages. Because of changes in credit quality or increases in interest rates, bonds can lose value. In this case, you might want to consider a bond swap. 

The idea is to sell the bond, take the tax loss or gain, and then go out and buy a similar security, but consider the wash-sale rule. Depending on the market, you could end up with a similar or better bond in, yet take the gain or loss. 

The Right Investments in the Right Accounts

When you go about looking for losses to harvest and when you add investments to your portfolio, it’s important to make sure that you’re holding investments in the proper account for tax reasons.

For example, qualified dividends are taxed at the preferential rate of 15 percent until 2010, so it generally makes the most sense to hold high-yielding stocks in a taxable account to take advantage of the potentially large differential in tax rates. Hedge funds, on the other hand, are best held in tax-advantaged accounts, since they are not very tax-efficient.

There are other tax-smart planning maneuvers you may wish to explore with your advisor, such as matching passive income gains with losses or looking for depreciation in limited partnership investments. Spend some time with your financial advisor to determine how to save money at year’s end.

You may want to consider qualified plan issues and limits; passive income losses to offset passive income gains – therefore, “tax-free” income; gifting issues that can not be carried forward; and issues specific to funding various college funding vehicles – to name a few.”

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