For many people, thinking about taxes is always a last-minute job. But even though millions of people still haven't finished their tax returns from last year, now's a great time to start looking at a smart tax strategy that could cut thousands off your tax bill next year. Even if you're an eternal procrastinator with your taxes, getting the jump on the competition could make things much better for you than waiting until the end of the year.
With the stock market up for the year, few investors are thinking much about taking tax losses on losing positions. But as the year progresses, you can expect other investors to pay more and more attention to their underperforming stocks.
The reason is simple: The IRS lets you claim losses on your investments against other income on your tax return, but only if you actually sell those losing investments. Once you sell, you can offset the resulting capital losses against any capital gains you have on winning stocks that you've sold during the year. Moreover, even if you use up all your capital gains, you can offset up to $3,000 more in capital losses against other types of income, including wages or interest income. Taken together, using this tax-loss harvesting strategy to offset income with losses can save you thousands on your tax bill next April.
Why you should do it now and not later
As far as the IRS is concerned, it doesn't matter whether you sell on Jan. 1 or Dec. 31. So long as you sell during the tax year, you get to claim your tax loss in that tax year.
But because many people wait until the end of the year to think about tax-loss harvesting, you'll often see an interesting phenomenon develop. Often, stocks that have fallen during the year will fall further in November and December, with one possible explanation being that tax-loss sellers are bidding down the stock, willing to sell at lower prices just to get a tax break.
By mid-year, it's not too hard to identify which stocks are going to be tax-loss targets come autumn. For instance, while many technology stocks have done pretty well so far this year, hardware specialists Hewlett-Packard (NYSE: HPQ ) and Dell (Nasdaq: DELL ) are sitting on losses of 25% or more over the past six months. Weak PC sales threaten their future prospects, especially considering that neither has a strong entry in the mobile space to replace its PC exposure.
International markets are also an obvious place to find tax-loss candidates. In Europe, Banco Santander (NYSE: SAN ) and Telefonica (NYSE: TEF ) are struggling with the Spanish descent into the worst of the financial crisis, even though both companies have extensive worldwide operations. But even some once-promising emerging-market stocks have taken it on the chin, with Petroleo Brasileiro (NYSE: PBR ) down more than a third in the past six months as oil prices decline and gradual steps toward nationalization in nearby Argentina raise doubts about South America's political stability.
A bonus for acting early
Apart from getting a necessary job out of the way, one added advantage of thinking about tax-loss selling early is that you have more choices on what you want to do next. Once you sell a stock at a loss, you can't buy it back until you've waited 30 days. Those who wait until December often get annoyed as a Santa Claus rally, followed by the fabled January Effect, ends up pushing shares much higher just after they've sold out.
But by selling early, you can buy back long before the year is out, potentially even picking up bargains if later tax-sellers cause prices to fall. Alternatively, if you think your stocks will rebound, you can buy more shares and then wait 30 days, effectively doubling up your position for a month but leaving you ready to sell your higher-basis shares with plenty of time to spare.
Moreover, most mutual funds do their tax-loss selling early, because their fiscal years end Oct. 31. You want to get in ahead of the funds, as well as your fellow individual investors.
Start saving today
Sure, July might be early to think about taxes. But the flexibility of the tax-loss harvesting strategy makes it worth considering long before the ball drops on Times Square.
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Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.