Five Years Later, Tax Lessons Learned

Five years ago, as the year 2009 dawned, investors weren’t celebrating. The broad stock market had crashed, many other asset classes had fallen as well, and pessimism had spread throughout the world.

As 2014 begins, investors’ spirits are brighter. Major stock market indexes are near record levels, real estate prices in many areas are recovering, and the U.S. economy seems to be growing steadily. Looking back, investors can learn some lessons. We’ve already had two severe stock market crashes in this century, and chances are that more downturns will appear from time to time. Taking advantage of certain provisions in the tax code can reduce your stress and keep you in position to benefit from the following upswing, whenever that might occur.

 Harvest capital losses

When stocks or other investments lose value, one possible reaction is to hold on until they recover. That may not be the best approach, however, for tax effective returns. Instead, consider selling investments that trade below your original purchase price. That will give you a capital loss; if all your trades in a given year produce more losses than gains, you generally can deduct up to $3,000 of net capital losses on that year’s tax return. A $3,000 net capital loss will reduce your adjusted gross income (AGI), and a lower AGI may provide various tax savings on that return. The tax advantages of harvesting capital losses go beyond a $3,000 deduction in the year of sale. Excess net losses can be carried over to future years, with no time limit. Example 1: In a future year, the stock market drops sharply and Lynn Matthews takes $40,000 worth of capital losses, her only trades that year. Lynn takes a $3,000 deduction and carries over the $37,000 balance. With $37,000 of net capital losses, Lynn has a great deal of investment flexibility. If the stock market recovers, as it has done in the past, Lynn can sell securities when it suits her investment strategy. She won’t have to consider the tax consequences of taking profits as long as she has a capital loss carryover to use as an offset. Recent tax legislation has increased the effective tax rate on capital gains for many high-income taxpayers. Such investors may benefit significantly from having a “bank” of capital losses to net against capital gains.

 Avoid wash sales

If you sell a particular investment at a loss and immediately buy back the same thing, you will have executed what the IRS calls a wash sale. Then you won’t be able to count the capital loss on your tax return. There are several ways to avoid a wash sale. One is to immediately invest in something different from the security you sold. Another is to wait more than 30 days and then execute a buyback. Either way, you can maintain the strategy you believe fits the current environment. Example 2: Suppose that Lynn Matthews took her $40,000 of losses in tech stocks and tech funds when the market tumbled. Now Lynn thinks the best opportunities lie in health care stocks, so she can reinvest there right away. On the other hand, if Lynn thinks the tech sector will bounce back, she can buy different tech stocks and funds—or she can wait more than 30 days and repurchase the holdings she sold. The important thing is that Lynn can invest the way she pleases, as long as she doesn’t enter into a wash sale. By staying invested, she will be in a position to use her capital losses in a future market recovery.

 Rebalance regularly

Many financial advisers believe that investors should have a predetermined asset allocation, based largely on their risk tolerance and their time horizon. Periodically, this asset allocation should be reviewed and, if necessary, adjusted back to the desired levels. With this strategy, investors may be able to buy low and sell high, which can generate favorable longterm results. However, the “sell high” portion of this plan might lead to taxable gains. If an investor has a bank of capital loss carryovers, rebalancing can be less taxing. Example 3: In a previous example, Lynn Matthews takes $40,000 worth of capital losses during a bear market for stocks. Lynn reinvests her sales proceeds in different stocks and stock funds. Indeed, she notices that her asset allocation to stocks had fallen below her desired level, so she sells bonds and buys stocks. The profitable gains from her bond sales can be offset by the losses on her stock sales. Going forward, if stocks rally and need to be trimmed in a future rebalancing effort by Lynn, any still unused capital loss carryovers can offset that year’s capital gains.

 Invest through employer plans

Many companies offer retirement plans such as 401(k)s. Contributions are untaxed, so the tax bill is deferred until money is withdrawn. In most such plans, contributions are automatically made via monthly paycheck withholding. While tax deferral is considered a prime benefit of these plans, periodic contributions also play a valuable role. If you contribute a certain amount each month to a designated mutual fund, you will buy more shares when prices are down, fewer shares when prices are up. This tactic is known as dollar cost averaging, and it is a valuable technique for lowering your cost per share and increasing future profits. Investors who maintained their retirement plan contributions during the 2008–2009 downturn bought more shares of stock funds during that time, so they gained more in the subsequent market rally. Persistent contributions to employer retirement plans can boost your long-term accumulation and do so with the added benefit of tax deferral.

Copyright AICPA

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