Everyone hates taxes. Even if you believe that government uses tax money for worthy purposes, it's still painful when it comes time to pay the piper, whether it's in April, through quarterly estimates, or in the money withheld from every paycheck. It's no surprise that people sometimes take extreme measures to reduce the amount of tax they have to pay.
Good tax planning is an important part of your overall financial plan. However, you always have to bear in mind that taxes aren't the only factor to consider in making decisions about your finances. Making taxes the primary motivation for your overall financial strategy is like letting the tail wag the dog. This article discusses a few tax-related strategies, with an eye toward making you think twice before automatically following the general rule.
Taking tax losses
Now that November has come, many people are starting to talk about taking tax losses. If you own a stock that has significantly fallen in value since you purchased it, you may be able to convert your paper loss into a tax benefit by selling your stock. If you sell, you then have a realized capital loss, which you can use to offset any capital gains you've already realized. Even if you don't have any capital gains, you can deduct as much as $3,000 of your capital loss against other types of income. Depending on your tax bracket, you can save quite a bit on your taxes by selling your losing stocks.
However, if you focus only on taxes, you may end up making an investment mistake. If you sell a stock when it's down, you may be sorely disappointed if it starts to rise again after you've sold it. For instance, in 2005, Pfizer (NYSE:PFE) lost about 25% of its value between the middle of the year and the end of October. People who had held the stock throughout its decline were probably tempted to sell it and reap the benefits of tax losses. Yet if you had sold Pfizer in the fall of 2005, you would have missed out on the resurgence of the stock's price, which erased the majority of the losses that year. Buying high and selling low is the bane of stock investing.
To solve this problem, you might think you could just buy back the stock the day after you sell it. Unfortunately, special provisions called the "wash sale rules" prevent you from doing so. To claim the loss on your taxes, you must not buy the stock within 30 days of selling it. So if you sell the stock with the plan of buying it back later, you still run the risk of missing out on any price appreciation during those 30 days.
One solution that gives you the benefit of upward price moves is to buy more shares of stock, with the idea of selling shares later to claim your loss. To meet the wash sale requirements, you still have to wait 30 days before selling. However, instead of having no position in the company while you wait, this strategy has you take a double-sized position. Although this adds risk if the stock price keeps falling, you don't have to worry about selling at exactly the wrong time if the price goes up.
Holding winners, no matter what
On the opposite side of the coin, it's likely that at least a few of your stocks will have large gains. As long as you hold on to those shares, you won't have to pay tax on those gains. As a result, many people who have big position in winning stocks never sell any of their shares, even if the financial situation of a particular company starts to deteriorate.
Keep in mind, however, that it's better to take a gain and pay some tax than lose it all. Plenty of investors learned this the hard way in 2000 and 2001, when a host of technology stocks like Amazon.com (NASDAQ:AMZN) and Yahoo! (NASDAQ:YHOO) lost the majority of their share value after racking up big gains in the late 1990s. Because they had made so much money, the prospect of paying large capital-gains taxes made investors reluctant to cut their positions. By the time many people decided to bite the bullet and sell, prices had fallen so much that in some cases, they no longer had gains at all.
Not owning bonds
Taxpayers in high tax brackets have probably noticed that under current tax rules, stocks get treated much better than bonds. With stocks, a significant portion of your profit comes from capital gains, which get taxed at a lower rate than most other types of income. Dividend income paid by most stocks also qualifies for a lower rate. On the other hand, interest payments from bonds don't get the benefit of lower rates, and they're counted as ordinary income for tax purposes. The tax savings can be substantial, since the dividend and capital-gains tax rates are less than half the highest rates on most other kinds of income.
Given the higher taxes on bond interest, it's tempting to load up on stocks. However, focusing solely on the tax savings ignores the larger issue of a diversified portfolio. With all of your savings in the stock market, you are fully vulnerable to market risk; if stocks fall, you have no other investments to help you weather your losses.
These are just a few examples of things people do in the name of lowering their tax burdens. While there's nothing wrong with any of these choices by themselves, you should always consider more than the tax impact when making your financial decisions. Sometimes, forgetting about taxes for the sake of your broader investment strategy is the right move.
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For a wide array of information on similar topics, check out our Foolish Tax Center. It's chock-full of helpful tips and advice to help you answer all your tax questions.
Amazon and Yahoo! made David and Tom Gardner's list of superior stock selections at Motley Fool Stock Advisor , while Pfizer is one of Philip Durell's bargain-priced picks at Motley Fool Inside Value.
Fool contributor Dan Caplinger will be paying quite a bit more tax than usual this year, but he doesn't mind -- too much. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy is never taxing.
