Personal Finance: Year-end gift: Book a loss
As Christmas approaches, don't forget the one gift Uncle Sam hands out to investors every year.
That's the gift of harvested capital losses. While most investors understand the importance of minimizing capital gains–to lower tax bills–many forget the power of booking capital losses in one's portfolio.
By selling securities that are trading below their original purchase price, you can realize losses this year that can be used to offset capital gains elsewhere in your portfolio dollar for dollar.
If you don't have any gains to offset, you can carry forward these losses for as long as you live. Or you can use your losses to reduce ordinary income by as much as $3,000 a year. Think about it: If you realize $3,000 of losses this year, you can reduce your taxable income by that amount. For someone in the 35-percent tax bracket, that works out to a tax savings of more than $1,000. In essence, Uncle Sam is willing to pay for some of your mistakes.
Now, if you are thinking of selling some losers before the end of the year, give serious thought to replacing them with other investments. Why? Because being out of the market even for a few months can be risky.
Of course, there's the IRS's "wash-sales rule" to be mindful of. That rule states that investors cannot repurchase shares they sold or buy shares of a "substantially identical" security within 30 days of the original sale. If you do immediately step back into a stock you sold at a loss, you won't be allowed to take advantage of the capital loss to reduce your taxes.
So what types of investments can you consider replacing your losers with?
- Other stocks. There's nothing in the IRS wash-sales rule that can stop an investor from replacing a losing stock with shares of a competing firm. So for instance, if you're down on Wal-Mart and want to sell, you can do so and simply replace that holding with shares of Target.
- Exchange-traded funds. ETFs are hybrid investments that trade like individual stocks. But like an index mutual fund, an ETF represents a basket of dozens of stocks that make up a market index, like the S&P 500 or a sector of the stock market. "ETFs can add or reduce exposure to a particular market, style, sector, country, or region with just a single trade," says Joseph Quinlan, chief market strategist for Bank of America's Investment Strategies Group. In this case, if you're thinking of selling shares of, say, Microsoft at a loss, consider buying an ETF that tracks the technology sector.
- Tax-efficient mutual funds. Increasingly, investors are utilizing tax-efficient portfolios, which manage money with taxes in mind. If you're thinking of replacing a losing stock with a mutual fund, consider a tax-managed fund first. That's because regular stock funds often distribute taxable capital gains to shareholders at the end of each year. By sticking with a tax-managed fund, there's less of a chance that you're going to buy into an immediate tax bill.