Make your investment decisions less taxing

By Dennis Murray
Senior Editor

These tips for buying and selling can help keep more money in your pocket—and out of Uncle Sam's.

Making money on investments is nice. Paying taxes on profits isn't. But with some smart planning, you can reduce your debt to Uncle Sam.

Hold your investments for longer than a year, whenever possible. Gains on your assets fall into two categories for tax purposes: short term and long term. Short-term gains are those made on assets you hold for a year or less. They're taxed at your ordinary income rate, which may be as high as 38.6 percent. Profits on assets sold after a year, on the other hand, are subject to the friendlier capital gains rate of 20 percent.

Don't purchase shares of a mutual fund until after it has distributed capital gains, dividends, or both. If you buy beforehand, you'll owe tax on a distribution that will, in effect, be a return of money you invested. That's because after a distribution, the fund's share price drops by the amount paid out.

If you're unsure of your fund's distribution schedule, visit the company's Web site or call its investor relations or client services department.

Be choosy about which shares you sell. Let's say three years ago you bought 100 shares of a stock or mutual fund at $40 per share, and the next year you bought another 100 at 55. The price has since hit 75, and you've decided to sell some shares. Unless you specify which ones you want to sell, the IRS will use the FIFO ("first in, first out") method to make that determination. Your taxable gain would be $35 a share: 75 minus your basis of 40. However, you could tell your broker (or the fund's customer service rep, if you're handling the transaction yourself) to sell the shares that cost 55 apiece. That reduces your taxable gain to $20 a share.

If you're selling shares in a fund that has steadily declined in value, however, you'd be wise to get rid of the most expensive ones. This will maximize losses and help offset taxable gains. In case you're audited, get written confirmation of which shares were sold, and when.

Generate tax losses by transferring money between mutual funds in the same family. "For example, someone who invested in Fidelity Blue Chip Growth Fund this year could move to Fidelity Growth Company Fund and realize a loss without changing their portfolio's asset allocation," says CPA Mary McGrath, of Cozad Asset Management in Champaign, IL. This strategy avoids any potential conflict with the IRS' "wash sale" rule, which prohibits you from writing off losses on a fund you sell and repurchase within 30 days.

Plan losses to offset gains. The IRS' pecking order requires you to take long-term losses against long-term gains first, and short-term losses against short-term gains second. Take a situation where you have $1,000 in short-term gains, $1,000 in long-term gains, and $1,300 in long-term losses. In this example, the $1,300 loss offsets the long-term gain first. The remaining $300 loss is used to offset the short-term gains. Conversely, remaining short-term losses can offset long-term gains, although this will only save taxes at the 20 percent rate. You can't choose instead to deduct $300 against ordinary income.

If you're single or file jointly and your losses exceed your gains, you can use up to $3,000 of the extra to offset regular income. (The limit for spouses who file separately is $1,500.) What if you have unclaimed losses beyond the $3,000 limit? You'll get a tax benefit down the road: The IRS allows you to carry over any unused amounts to future tax returns, until you're able to write them off entirely. For instance, if you had a $4,500 net loss in 2002, you could use $3,000 of it on your return for that year and claim the remaining $1,500 on your return for 2003.

"Remember, though, that the unused losses have to keep their status as either short term or long term when they're used in the future to offset gains," says Robert G. Baldassari, a CPA with Matthews, Carter & Boyce in Fairfax, VA.

 

Dennis Murray. Make your investment decisions less taxing. Medical Economics 2002;24:30.