NEW YORK Aug 16 Sometimes, it makes sense for the tail to wag the dog. That's what experts call it - often with derision - when investors let tax considerations drive their investment decisions. Theoretically, you're only supposed to make investment moves based on your investment goals.
But still, if you've been in the market for the last two weeks, there's a good chance you have some sizable losses and gains. With some strategic selling and buying, you can lock in a tax break that will make you happy next April.
From a tax standpoint, "now is a good time to perk up the whole portfolio," suggests Mary Kay Foss, a Danville, California, certified public accountant. "But I think right now most clients aren't listening to my advice. Some of my clients are so shell shocked ... (by last week's market gyrations) ... that they weren't ready to take action."
Here's what you need to know to make the most of those tax breaks. If all of your investments are in tax-deferred retirement accounts, you can stop reading now: The gains-and-losses strategy won't apply to you.
LOSSES ARE VALUABLE
When you lose money on a long-term investment (one you've held for more than a year), and you sell it, you "realize" the loss. That means you can use that loss to offset any long-term gains you've also realized. And you can use an additional $3,000 of loss to reduce ordinary taxable income. If you end up with more losses than that, you can carry them forward and use them, year after year, until they are used up.
Short-term losses are even more valuable. That's because short-term losses (those on investments held a year or less) offset short-term gains, which are taxed at a higher rate than long-term gains. Short-term gains are typically taxed at your regular income tax rate, instead of the preferable 15 percent rate applied to most long-term gains. You can use those short-term losses to offset $3,000 in ordinary income, too, and also carry them forward.
Being able to take a loss provides a serious selling opportunity, Foss notes. Even though the overall market has recovered from last week's big sell offs, you may still have losses in specific investments. (Bank stocks, anyone?). And if you locked in some losses, that affords you the opportunity to sell winners, too. Say, for example, that you've been sitting in a growth stock mutual fund and you'd rather be in a dividend stock fund, but you were afraid to sell the growth fund shares for fear of triggering a capital gain. You can use new losses to cover gains you might realize when you rejigger your portfolio.
"If you've got some losses that look solid, look at some of those profit positions that you don't want for the long haul," says Foss. It doesn't make sense to wait until the end of the year to make all of your portfolio adjustments if the tax implications work now.
If your goal is to be invested, then don't sell your shares and park your money on the sidelines. Otherwise, you could end up locking in a tax loss and losing a bucket of money. Consider those people who, for example, sold at the end of the day on Monday, Aug. 8, when the Dow Jones Industrial Average dumped 624 points, and then failed to buy back in in a timely manner. The following day the index was up 429 points. On Monday, Aug. 15, the Dow surpassed its pre-Aug. 8 high. That would have been a costly sale.
Sell your shares to lock in your tax gains and losses, and then immediately buy something different, so your overall investment strategy remains in force.
Tax pros know all about the so-called "wash sale rule." That prohibits investors from selling an investment to lock in a loss and then turning around and buying the exact same security immediately. You have to wait 30 days to buy back the same shares. In most cases, you can instead buy something similar, but different. Even an index fund that is a different brand than the index fund you sold fits that bill. And beware of mutual funds in which you are reinvesting dividends or automatically investing money every month: The shares you bought in the month before you sell will put you in violation of that wash sale rule, too.
If you do run afoul of the wash sale rule, you won't go to jail, you'll just lose the ability to take a loss. Instead, the "loss" will get added to your original basis in the stock, so you'll reap that benefit at a later date, explains Kaye Thomas of www.Fairmark.com, a tax publisher. For example, if you bought shares for $20, sold them at $10 and immediately rebought them at $11, your new "basis" - the purchase price used for calculating future gains and losses, becomes $21. That's calculated by adding the initial "loss" to the new purchase price.
The process is complex, but worth learning. At a combined federal and state income tax rate of 35 percent, every $3,000 in extra losses will save you $1,050 a year. That's worth a little homework, and some wag-the-dog strategizing, no? (Editing by Beth Gladstone)