Originally posted October 29, 1999
Year-End Tax Planning Tips
Check the status of taxable gains and losses in your portfolio: Now is a good time to see if your investment allocations (the balance among stocks, bonds, mutual funds, cash, etc.) are consistent with your original plans. Because of the significant run-up in the stock market over the last number of years, you may find that your intended weighting for stocks in your portfolio (70% for example) may have increased substantially. You may find that your stock weighting is now 80% or 90%. If that meets with your current plans, great! But, if it doesn't, you may want to review your portfolio, sell some assets, and redeploy the cash elsewhere.
Obviously, for investments in a tax-deferred environment -- such as an IRA, 401(k), SEP-IRA, 403(b), etc. -- you'll realize no tax consequences if you decide to sell certain stocks... regardless of whether you sell at a profit or loss. But, for your investments that are not in a tax-deferred account, your decision of what and when to sell could be critical from a tax standpoint.
You'll want to review your portfolio to see if you already have realized gains (from stocks you sold at a profit) over the past year. If so, you may want to sell some shares and take some losses now to offset those gains. And remember -- if you're a mutual fund investor, you'll likely also be receiving capital gains distributions from your various funds... and those capital gain distributions also qualify as gains that you can offset with stock losses.
Remember also that you'll receive a preferred tax rate for your long-term capital gains (gains on shares held for more than one year), but you'll pay taxes at your "ordinary" rate on short-term gains. You really don't want to disturb any of your long-term gains unless you can't help it. To protect the preferred tax rate you'll receive with these gains, be careful when looking at what assets to sell and the losses that you might want to take. It's very possible that short-term losses you realize will impact your long-term gains -- not something that you may really want.
So, while you're going through this exercise, make sure to categorize your gains and losses by short-term and long-term components. Try to take short-term losses only against short-term gains. Whenever possible and prudent, allow your long-term gains to be taxed at the preferred tax rate rather than to offset them with short-term (or even long-term) losses. As a rule of thumb, you want to keep your long-term gains intact and use any losses (either short- or long-term) to offset any short-term gains.
Because of the requirements to segregate your profits and losses by short-term and long-term components on the tax return, this can get very tricky. But it's certainly something to consider and something that you'll really want to pay maximum attention to when looking at your portfolio and deciding which stocks to sell and which to keep.
Also remember that, to the extent that you have losses, those losses will first go to offset any gains. If you have more losses than gains, up to $3,000 ($1,500 if you are married filing separately) of those losses can then be used to offset other income (such as wages, interest, dividends, etc.). If your losses exceed $3,000 (or $1,500 if you file married/separate), you must carry over (but not back) those losses into the year 2000.
Be picky when liquidating stocks, mutual funds, or DRIP shares that you have purchased over time: In conjunction with your portfolio review, you may find that you want to liquidate an investment that you have purchased and/or accumulated over months (or even years). You may still love the investment, and it may still make sense for you to hold it for the long term... so you simply want to sell a portion of that investment. Since you'll be selling less than your entire position in the investment, you'll generally want to sell the shares that will give you the least tax impact. That would be the shares with the highest basis (or cost... for tax purposes).
Generally, those would be the shares that you've held for the shortest period of time. By selling the shares with the highest basis, you'll reduce your exposure to that specific investment, generate cash to be used as you see fit, and minimize your tax liability on the sale.
If you find that the shares you want to sell aren't the first ones you originally acquired, you'll have to do some fancy footwork in order to "specify" the shares that you want to sell. Remember, when you're dealing with most stock investments, you're stuck with the FIFO (First In-First Out) method of accounting for that investment. But, you can overcome the use of the FIFO requirement if you can actually "specify" the shares that you wish to sell.
The tax issues regarding "specifying" shares can be a bit complex. We discuss those issues in our FAQ on that very subject... you might want to check it out. Additionally, Kaye Thomas speaks to the issue of specifying shares on his website (Fairmark.com) and provides you with tips that you might use. But, you must know that the process that must be followed when you want to specify shares can be a bit complex... there are certain rules the IRS requires you to follow. So, make sure that you understand those rules and comply with them before you attempt to specify certain shares.
Basically, you'll need to indicate to your broker the specific shares that you are selling, usually by reference to the original purchase price and purchase date. In order to complete your tax records, the broker will need to send you a written confirmation of your instructions, and also a confirmation of the shares sold, within a reasonable time after the sale.
You may be thinking, "I use an online broker... I'll never get a written confirmation." And you may be right. But that doesn't necessarily mean that you can't use the specific-share method of accounting for your transactions. So don't automatically dismiss the possibility. Take the time to read and study more about how you can use the specific-share method in my FAQ and at the Fairmark website.
Year-End Tax Planning Tips
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