Consider Taking Advantage of Stock Losses
Year-End Tax Planning for 2002
By Alexandra Armstrong, CFP, CMFC
with Karen Preysnar, CFP
April
15th is traditionally known as "tax day," since that's
the day your tax return is due. We think Dec. 31 is an important
tax day as well for informed investors, however, since in most
cases that is the deadline for taking steps to reduce your income
taxes for the past year.
Here are some areas
we suggest you review now before the less recognized Dec. 31
tax day arrives. Keep in mind a new 10 percent tax bracket was
put in place for 2002. The former 28, 31, 36 and 39.6 percent
tax rates dropped to 27, 30, 35 and 38.6 percent, respectively.
In addition to the drop in tax rates, here are some steps you
can take to further reduce your tax liability.
Reduce Your Investment Portfolio
Start
by reviewing the securities you have sold so far this year to
see whether you have a net gain or a net loss. You might want
to use a blank Form 1040 Schedule D as your worksheet to make
this task easier. The 2001 form can be downloaded from the IRS
Web site at www.irs.gov; click on the Forms and Publications
link on the home page to reach it.
Group all your short-term
gains and losses and net them against each other. Short-term
gains and losses are for those securities you held one year or
less. Do the same for your long-term gains and losses. Be sure
to include any losses you might have carried forward from 2001
in each of these calculations.
To determine whether
you have a carryforward loss from last year, check your 2001
federal tax return. If Line 13 on your Form 1040 shows a gain,
or if it shows a loss of less than $3,000, you do not have a
carryforward loss. If Line 13 shows a loss of $3,000, chances
are that you have a carryforward loss. Review your 2001 Schedule
D and the capital loss carryforward worksheet to determine whether
your carryforward loss is short-term, long-term, or both.
Once you have figured
your net short-term gain or loss and your net long-term gain
or loss, combine these figures to determine your overall gain
or loss. If the result is a net loss, the maximum excess capital
loss you're allowed to deduct in one year is $3,000. If your
net loss is larger than this amount, it can be carried forward
to next year.
If the overall result
is that you have a net short-term gain, it will be taxed as ordinary
income unless you offset it with deductions or additional losses.
If you have a long-term gain, it will be taxed at a maximum federal
rate of 20 percent (10 percent to the extent you are in the 10
or 15 percent tax brackets).
Next, review your current
holdings to determine whether you should make any other sales
before year-end. If you have an overall net gain year-to-date,
particularly a net short-term gain, review your portfolio for
sales that will result in a loss. When calculating the cost for
mutual funds, remember to add any dividends or capital gains
you have reinvested into additional shares to your cash investments
in the fund.
Also
keep in mind that if you sell a security (stock, bond, mutual
fund) for a loss, you cannot buy that security back within 30
days after the sale date or else your loss will be disallowed
under the "wash sale rules." The loss is also disallowed
if you purchased the stock fewer than 31 days before selling
it. One way to lock in a loss without being out of the market
for 31 days and without violating this rule is to purchase a
different, but similar, security a stock or mutual fund within
the same industry, for example.
If you like a stock
for the long run but would like to sell it this year for a loss,
another strategy is to double-up on the position more than 30
days before selling it. Then after waiting 31 days or more you
can sell the higher-cost shares. You'll create a tax loss and
will still be left with the same number of shares you had originally.
Remember to factor in fees and commissions on both the buy and
sell transactions before doing this.
For example, let's
say you have net long-term capital gains of $5,000 so far this
year. Also assume that you purchased 200 shares of Company A's
stock several years ago at a total cost of $10,000 and that the
stock is now worth $6,000, or $30 per share. You buy an additional
200 shares at a total cost of $6,100, and after 31 days you sell
your original 200 shares for net proceeds of $5,900. Your tax
loss is $4,100 ($5,900 - $10,000), and your tax savings is $820
(20 percent of $4,100). You paid $200 in transaction costs, so
your net saving is $620. And you still own 200 shares of Company
A's stock.
If you have a net loss
year-to-date, you may want to review your portfolio for sales
that will result in a gain. But don't sell something just to
use up your losses sell only if you have other reasons for doing
so as well. After all, excess capital losses aren't lost just
because you can't deduct them all in the current year. Capital
losses can be carried forward indefinitely until they are used
up.
Remember to consider
capital gains distributions from mutual funds when figuring your
tax situation. This year, like last year, fund companies are
less likely to pay substantial gains because of the declining
markets. This doesn't necessarily mean that a fund won't declare
any capital gains distributions. Transactions within a fund's
portfolio may still result in a gain, since some of the fund's
positions may have been purchased several years ago.
Fund companies generally
begin releasing their estimates of year-end distributions in
early November. You can contact the fund company or your financial
adviser for this information. Be sure to ask whether the expected
gains are long-term or short-term.
If you're selling a
mutual fund, find out when the ex-dividend date is. If you own
the fund on the ex-dividend date, you will be paid the capital
gain even if you don't own the fund on the date the gain is actually
paid. You may want to sell the fund before its ex-dividend date
because you'll have to pay taxes on that gain even if you have
a loss in the fund overall.
When searching for
gains or losses in your portfolio, look at the specific cost
for your shares instead of their average cost. If you bought
a stock at several different times, you can select the shares
you want to designate as sold. But you need to keep a careful
record of which shares you designated as sold for future years.
Many people don't know
that this approach can also be used with mutual fund shares.
Let's say you have been investing regularly in a fund and bought
some shares of it in 1990 and 1991, when most prices were higher.
If you need a loss, you might sell some of these shares.
Contribute to a 529 Plan
Contributions to a Section 529 college savings plan or prepaid tuition plan are treated like other gifts to individuals with one important exception: You can give up to five years' worth of gifts in one year. This means a couple can contribute up to $110,000 to a 529 plan this year for an individual if they haven't made other gifts to that beneficiary in 2002 and if the couple files the appropriate gift tax election form.
Bunch Your Deductions
Since
itemized deductions are phased-out for higher-income taxpayers,
you could benefit by grouping your deductions in one calendar
year. In 2002, if your adjusted gross income exceeds $137,300,
you'll lose 3 percent in itemized deductions for every dollar
your AGI exceeds this limit.
Deductions excluded
from this rule are allowable medical costs, theft/casualty losses
and investment interest expenses. Bunching may be particularly
helpful for miscellaneous itemized deductions (fees for tax preparation,
financial planning and investment advice, for example) that have
to exceed 2 percent of your AGI to even be considered a potential
deduction.
We encourage you to
sit down in November and decide whether you need to take any
action before year-end to reduce your taxes. We have given you
some general guidelines, but we strongly recommend you check
with a professional tax advisor before making any changes.
Editor's Note:
Alexandra Armstrong is a Certified Financial Planner practitioner,
a registered investment advisor, a registered representative
with FSC Securities Corporation and chairman of Armstrong, MacIntyre
& Severns, Inc., Washington, D.C.
Individuals should
contact a financial planner, tax advisor or attorney when considering
these issues. Karen Preysnar, CFP, co-author of this article,
is vice president in charge of financial planning at Armstrong,
MacIntyre & Severns, Inc., and is a registered representative
with FSC Securities. She has provided financial planning advice
for more than 19 years. Their article appeared in NAIC's Better
Investing magazine. NAIC is a national, non-profit organization
of investment clubs and individual investors. Visit the web site
at www.better-investing.org.
