Year-End Tax Planning Tips, Part II
Portfolio Planning

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By Roy Lewis

In Part I, we discussed a few tips that might make this year a little less "taxing." In Part II we cover a few more.

Check the status of taxable gains and losses in your portfolio: See if your investment allocations (the balance among stocks, bonds, mutual funds, cash, etc.) are consistent with your original plans. Significant stock market run-ups can substantially increase your intended weighting in stocks, for example. If that meets with your current plans, great! If it doesn't, you might 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 investments that are not in a tax-deferred account, your decision of what and when to sell could be critical from a tax standpoint.

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 might want to sell some shares and take some losses to offset those gains.

If you're a mutual fund investor, you'll likely also be receiving capital gains distributions from your various funds at the end of the year, 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 might 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 offseting 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.

Be picky when liquidating stocks, mutual funds, or Drip shares that you have purchased over time: You might find that you want to liquidate an investment that you have purchased and/or accumulated over months (or even years). You might still love the investment, and it might 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 acquired, you'll have to do some fancy footwork to "specify" the shares 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, so if you're going to use this gambit, make sure that you understand what must be done.

Catch Up Your 401(k) Contributions: As you know, there are maximum limits to 401(k) contributions each year. Generally, your 401(k) contributions must be made throughout the year, but did you know that some 401(k) plans allow for "catch-up" contributions in December if your contribution level is less than the maximum allowed? Using your December bonus to fund the balance of your 401(k) (when allowed) might be a good way to dodge some current taxes. If your employer matches some of your catch-up contributions, you're in even better shape. Not all 401(k) plans allow for this "catch-up" provision, so check with human resources or your company's benefits administrator.

Tax Credit Planning: Tax credits are much more valuable to you than deductions. Don't overlook any of them. Here are just a few of the most common credits -- the list is not inclusive by any stretch of the imagination:

  • Child Tax Credit: A tax credit of $500 per qualifying child under the age of 17 is available. The credit is phased out when your modified Adjusted Gross Income (AGI) exceeds $110,000 for married-joint filers, $55,000 for married-separate filers, and $75,000 for all other taxpayers.

  • The HOPE Credit: This is a credit of up to $1,500 per student for qualified tuition and fees paid by the student, or on behalf of the student.

  • The Lifetime Learning Credit: This is a credit of up to $1,000. The student is not required to be enrolled on at least a half-time basis (which means that part-timers can qualify). Also, the education does not necessarily have to be for the acquisition of a post-secondary degree or specific business purpose.

  • Child and Dependent Care Credit: If you pay somebody else to care for your child under age 13 to allow you to work, this credit could be available to you. The credit is on an inverted scale with respect to your AGI, which means the higher your income, the lower your credit.

  • Adoption Tax Credit: If you have recently adopted a child, you could be eligible for this credit. The total credit can amount to $5,000 per adopted child (or up to $6,000 per "special needs" child).
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