- How Investment Losses Can Help Lower Your Federal Income Taxes
How Investment Losses Can Help Lower Your Federal Income Taxes
As stock markets plummeted in 2008, investors lost trillions of dollars in assets.
Some investors, however, can use a key year-end strategy called "tax loss harvesting," to reduce their taxes and help soften the blow.
But it applies only to investments that are taxable -- not to investments inside any retirement savings plans, such as IRAs and 401(k)s.
Taking investment loss can provide tax breaks over more than one year
Loss harvesting involves selling investments like stocks and mutual funds to realize losses. You can then use those losses to offset any taxable gains you have realized during the year. Losses offset gains dollar for dollar.
And if your losses are more than your gains, you can use up to $3,000 of excess loss to wipe out your tax bill on other kinds of income, such as your wages, savings interest or rental income.
If you have more than $3,000 in excess loss, it can be carried over to the next year. You can use it then to offset any 2009 gains, plus up to $3,000 of other kinds of income. You can carry over losses year after year for as long as you live.
Be careful of "losses" that are actually gains
Even in taxable accounts, falling prices don’t automatically translate to tax losses. That only happens when you sell a security to transform your “paper loss” into a real loss. Sometimes, in fact, dumping a beaten and bloodied stock can even produce a taxable profit.
How’s that?
Remember, your profit or loss isn’t the difference between a stock’s peak value and what you sell for; it’s the difference between the price you paid and what you sell for.
Say you bought shares for $10 each many years ago and they soared to $50 when the market peaked in October 2007. If you sell tomorrow for $15 a share, you could feel that you’ve suffered a 70 percent loss. But in the eyes of the IRS, you have a 50 percent gain.
That’s why it’s so important to carefully review the “tax basis” of shares in your portfolio when planning year-end sales. Your basis is what you have invested in the stock or the mutual funds shares.
Since it's up to you when to sell securities — and convert paper gains and losses to real ones — you can mix and match your trades to deliver the tax outcome you desire.
Assess your investments first
Begin with an outline of exactly where you stand. Draw up a list of your trades so far and the gains or losses on each. Make another list showing your current holdings and the paper gain or loss to date. In other words, if you sold the securities today, what would your profit or loss be?
Because the tax law treats different kinds of gains differently, you need to segregate your long-term (for securities owned more than one year) and short-term sales (for securities owned one year or less) so far this year and your open positions that would produce each kind of gain or loss.
If you invest in mutual funds, check with the fund about how coming year-end distributions might add to your capital gains for the year.
A strategy for net gain
If you are fortunate enough that your trades so far in 2008 have resulted in a net gain, take a hard look at the securities in your portfolio that show paper losses.
Maybe now is the time to unload some of those stocks, using the loss to sop up the gain on other deals and lower your tax bill. It's not a cockamamie idea to realize losses to save on taxes. After all, you suffered the loss when the securities fell in value. Selling just makes it official… and makes the IRS pick up part of the loss.
What if you have a net short-term gain, which will be taxed at your top tax bracket? Taking any kind of loss — short or long term — can offset that gain dollar for dollar.
And, although long-term gains get favorable tax treatment, net losses from either category can be deducted in full against other income such as your salary, up to a $3,000 annual maximum write-off. Any net losses beyond the $3,000 write-off are carried over to cut your tax bill in the future.
A strategy for net loss
On the other hand, if your sales so far have produced a net loss, perhaps you should go in for some year-end profit-taking. As noted, only $3,000 of net losses a year can be used to offset income other than capital gains, so if you have a bigger loss, you have an incentive to cash in some of your other profits.
Because the loss will offset additional gains dollar for dollar, you can add to your income without adding to your tax bill.
Of course you don't want to let the "tax tail wag the investment dog" by allowing the search for tax savings to lead you into bad investment decisions. Your investment goals must be paramount. But if a particular investment is on the sell-or-hold borderline, perhaps the tax consequences can be decisive.
Last-minute sales
Since it takes several days to settle a trade — between the time you order the sale to the time you get your money — sales during the last few days of the year often straddle year-end.
As far as the IRS is concerned, a gain or loss should be reported on the return for the year the trade occurs, regardless of when settlement takes place. That means profits and losses taken as late as the closing bell on New Year's Eve go on the current year's return.
