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Locking in Gains? Don't Make This Mistake

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With the fiscal cliff looming and tax hikes looking increasingly likely at least for high-bracket taxpayers, many investors are going against the usual grain and selling off their winning stocks. In doing so, though, a substantial number of those investors are making a mistake that could cost them big gains if historical market patterns play themselves out.

Turning tax strategy on its head
Year-end tax strategies usually get fast and furious during the last week of the year, as procrastinators scurry to get as much tax savings as possible in under the Dec. 31 deadline. This year, though, things are a lot different. With tax rates scheduled to go up on Jan. 1, many investors have the same drive to do last-minute tax planning. But instead of trying to reduce taxable income, many taxpayers are seeking to pull as much income into the 2012 tax year as they possibly can, aiming to pay taxes at current relatively low rates rather than facing higher rates in 2013 and beyond.

One strategy that investors are using is voluntarily selling winning stocks to lock in gains. Although some of these investors are trimming positions to manage risk, others would prefer to hold on to their shares and just want the gains for tax purposes. Yet if you don't correctly understand a basic rule of tax law, you could miss out on an opportunity you may not realize you have.

Wash sales, losses, and gains
The rule you need to understand is called the wash sale rule. It's a fairly complicated part of the tax code that prevents taxpayers from manipulating purchases and sales of stock in order to avoid taxes.

Specifically, the wash sale rule says that if you sell a stock at a loss and then buy it back within 30 days of the sale, then for tax purposes, the sale and subsequent buyback are treated as a "wash." As a result, any loss that you realized from the initial sale gets wiped out, and you have to wait until you sell the newly purchased shares to claim that loss.

Clever attempts to work around the rule don't work. Using a different brokerage account -- whether it's a regular account or an IRA -- to buy new shares after selling the old ones isn't sufficient. Using options also isn't allowed as a workaround to the wash sale rule.

So what's the mistake? It's a simple misunderstanding: The wash sale rule doesn't apply to gains. So you don't have to wait 30 days to buy back stock you sell at a gain -- even though many investors think they do and are acting consistently with that mistaken impression.

Opportunity cost
Being out of a stock for a month may not seem like such a big deal. But January is often a big month for the stock market and for individual stocks in particular, as investors seek to deploy bonuses and other income into the market. The impact is so well established that it has a name: the January Effect. And although the January Effect doesn't happen every year, it's a risk you don't have to run.

For instance, consider these stocks from last year:

  • Sears Holdings (NASDAQ: SHLD  ) came into 2012 near its lows on news it would have to close more than 100 stores. Yet the stock climbed more than 50% in the first three weeks of 2012 and went on to more than double as CEO Eddie Lampert took steps to try to unlock the value of Sears' assets.
  • Pharma and biotech stocks had suffered mixed fortunes in 2011, with Dendreon (NASDAQ: DNDN  ) having sunk on disappointing sales of its Provenge drug. Yet in the first eight trading days of this year, Dendreon posted a nice sales surprise, and hepatitis-drug prospects Idenix Pharmaceuticals (NASDAQ: IDIX  ) and Inhibitex soared when Bristol-Myers Squibb (NYSE: BMY  ) bought Inhibitex in answer to Gilead Sciences' (NASDAQ: GILD  ) $11 billion purchase of Pharmasset.

If you sold those stocks at the wrong time to claim a loss and waited 30 days to buy them back, you missed out on some colossal gains. And while those stocks may not be the ones to experience jumps in early 2013, the stocks you own just might -- making it crucial not to make an unnecessary mistake in staying out of the market.

Know the rules
Tax planning is smart, but you have to know what you're doing. Otherwise, you can fall into traps that cost you a lot of money.

Unfortunately, Dendreon's rocket ride in January gave way to stock losses during the rest of the year, as revolutionary prostate cancer vaccine Provenge became a lightning rod of debate. Find out whether Dendreon can regain its former glory from Fool senior health care analyst David Williamson, whose brand-new premium research report on Dendreon addresses every key issue facing the company. The report also comes with a full year of analyst updates, so claim your copy of this exclusive report today by clicking here now.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 28, 2012, at 2:35 PM, pondee619 wrote:

    "Although some of these investors are trimming positions to manage risk, others would prefer to hold on to their shares and just want the gains for tax purposes"

    What does "just want the gains..." mean?

  • Report this Comment On December 28, 2012, at 4:58 PM, TMFGalagan wrote:

    @pondee619 - Just want the gains = just want to realize their capital gains and include them as taxable income on their 2012 returns at current low rates, and ideally rebuy the shares with a higher cost basis that will reduce future taxable gains by the amount of gain they just realized.

    best,

    dan (TMF Galagan)

  • Report this Comment On December 29, 2012, at 6:43 AM, skypilot2005 wrote:

    Dan C.,

    Thanks, for the article.

    Some of us have multiple 401Ks and I. R. As. we trade in with no tax consequences.

    I have my D. D. & watch list handy, “safety” off and finger on the “trigger” waiting for Monday. It will be a “full” trading day.

    http://www.nyx.com/holidays-and-hours/nyse

    Some of us also, work for "The Government" and

    have the day off.

    Hmmm....

    We’ll see what happens.

    Happy New Year to all Fools,

    Sky

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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