With these strategies, you can help ensure that Uncle Sam doesn't get more than he's due.
Keep winners for more than a year.
You can deduct up to $3,000 in unused losses against regular income.
Americans can't seem to resist flocking to what's hot, be it an electronic gadget, type of automobile, or vacation destination. They act no differently when it comes to mutual funds. The higher a fund's returns and the better the press it gets, the more likely people are to buy it.
For some people, tax savings are hallowed ground. An elderly client insisted we purchase tax-free municipal bonds for her, even though, in her low tax bracket, she would have done better with taxable bonds. As she put it, "I don't want to pay the government one red cent more than I have to."
Frankly, no one does. But you can save or postpone taxes on your investments in many more sensible ways. A simple tactic is to wait until after New Year's Eve to sell your winning investments, so the gains aren't taxable on this year's return. Moreover, if at all possible, hang onto your winners for longer than a year. When you sell, you'll pay the new long-term capital gains tax rate of 15 percent. By comparison, gains on investments held a year or less are taxed at your regular income rate, which can be as high as 35 percent.
Having a bad year in the market? Before December rolls around, think about selling some of your losers if the prospects for them look bleak, and to ensure you don't get hit with a taxable year-end dividend distribution. If your losses exceed your gains, you can deduct up to $3,000 of the excess against other income and carry over any amounts above $3,000 to future tax returns.
If a sick or elderly relative has named you an heir, ask this person to avoid selling any appreciated assets. Why? Because when you inherit them, you'll receive a "step-up" in basis. That means the new cost basis for computing taxable gains will be the assets' fair market value on the day the person dies. The step-up can eliminate taxes altogether, or significantly reduce them if you decide to hold the assets and sell them later.
For example, say eight years ago your mother bought 100 shares of a stock at $10 a share. The market price has since increased to 60 a share. If she sells the shares, her basis for tax purposes will be $1,000. She will owe long-term capital gains taxes on $5,000 ($6,000 minus $1,000), and your potential inheritance will be that much smaller. With a step-up, though, the new basis would be $6,000. In other words, the same shares would be treated as if you'd paid $6,000 for them.
To further take advantage of this opportunity, it may be worthwhile for a healthy spouse to transfer assets to a sick partner, who'll in turn leave the assets to the healthy partner at death. This would create a new, higher basis for the surviving spouse. In general, though, the transfer has to occur at least a year prior to death to pass muster with the IRS.
If you're inclined to give to charity, consider donating stock instead of cash. You'll get a deduction for the full value the stock had on the date you donated it. You can further whittle your tax bill by giving before the company distributes dividends, which are taxable to shareholders. One doctor client of mine contributes more of his assets to charity now that he knows this strategy.
In general, I don't believe in letting the tax tail wag the investment dog, though. Most of us have had poor investments that we're tempted to sell late in the year. In the right circumstances, selling to harvest the tax loss is a good idea, as I mentioned earlier. But here's what can sometimes happen: When many people who've invested in the same loser run for the exits, the stock's price becomes depressed. Then the shares often bounce back early in the new year. So sometimes it's better to forgo the sale's temporary tax benefit and hang onto the shares.
Lewis Altfest. Investment Consult: Smart investment tax moves.
Aug. 22, 2003;80:16.