Taking positive steps in a volatile stock market

 

 

The stock market continues to be very volatile and all of us are waiting to see what the immediate future brings. However, there are two positive steps you can take now in your taxable accounts (not your retirement accounts, e.g. 401(k)s, IRAs, etc.) to improve your income tax situation.

The strategies are:

 

• To purposely realize tax losses now so that you can use them to offset future capital gains (called tax-loss harvesting); and
• To sell mutual funds now, before the funds make their annual distributions (which usually occur in December), and by doing so, avoid paying the income tax that may be created by those distributions.

 

Strategy no. 1

Tax-loss harvesting involves selling investments that have suffered losses and then “banking”™ those losses so they can be used to shelter future capital gains in your portfolio or elsewhere. It works as follows: You would sell, now, an investment that has suffered a loss. By selling the investment you would “realize” (that”™s IRS-speak) the capital loss for income-tax purposes. These losses could be used to offset any capital gains that you have in 2008, and further, if your capital losses exceed your capital gains in 2008, the excess losses can be carried forward to future years (indefinitely for individuals) and used to offset capital gains in future years.

 

A simplified example: You own a stock that you bought for $300,000, but now it”™s worth only $200,000. If you sell it, you will have “realized” a $100,000 loss. Fast forward to 2009 or beyond, and assume you have (and choose to “realize”) a capital gain of $100,000 on another asset. Ordinarily that gain would be subject to capital gains tax, and assuming a federal capital gains rate of 15 percent, the tax on that gain would be $15,000 plus whatever additional state income taxes are due. However, if you had harvested your 2008 capital loss of $100,000, you would be able to use it to offset the 2009 $100,000 gain, and thus would pay no tax on that gain. In practice, of course, it”™s a little more complicated (the tax code always is), but the concept and potential tax savings are very real.

 

In fact, it could be even better, for the following reasons:

 

Although the maximum federal capital gains rate is currently only 15 percent, most commentators believe it will be increased in the near future. Remember that it was 28 percent as recently as the late 1990s, and even reached 39.9 percent in 1976-1977. If the rate does indeed go up, then any tax-loss harvesting you do now may save you even more in taxes later.

 

You are generally permitted to deduct up to $3,000 of realized capital losses each year against your ordinary income (i.e. salary, bonuses, interest). Thus, if you are in the highest federal income tax bracket (35 percent in 2008), a $3,000 deduction translates into a current savings of $1,050, plus whatever the state income savings would be.

 

Strategy no. 2

It”™s important to remember that mutual funds are similar to “pass-through entities,” which means that in essence the tax liabilities incurred by the fund when it holds or trades securities are passed through to the mutual-fund shareholders, that is, to you. By law, funds have to distribute to their shareholders at least 98 percent of the dividends and capital gains they accumulate over the course of the year. Most stock funds make their annual distributions in December.

 

When a serious market decline occurs, and a mutual fund loses significant value, many investors panic and sell their mutual-fund shares. The mutual fund, in order to raise the cash necessary to pay the selling shareholders, may be forced to sell long-held stocks in which it has substantial gains, and thus “realize” those gains. This has an unfortunate consequence, which is that it creates taxable gain in the mutual fund that must be distributed out to the remaining shareholders in December. The end result is that a mutual-fund shareholder who is still invested in the fund when it makes its annual distribution in December may have seen his or her investment lose significant value over the past year, but still be hit with a large capital gains distribution on which tax will have to be paid the following April. A potential solution is to sell the mutual fund before the distribution takes place (technically, before the “record date”), and in this way, the investor would avoid the December distribution and the additional income taxes it creates.

 

Important considerations

Most seasoned investment advisers believe the proper response to the current market decline is to stay invested in the market and to wait for it to recover, as it always has. The risk you run in being out of the market, even for a short period of time, is that historically, when the market recovers, it often does so in very quick bursts, with dramatic gains over the course of a day or two, or perhaps a week. If you happen to be out of the market when those dramatic gains occur, then losses that might otherwise be only temporary paper losses could be turned into permanent real losses.

 

Also, unless a client”™s investment objectives or time horizon have changed, most investment advisers will not recommend significant changes to his or her asset allocation, even in a down market.

 

Obviously, tax-loss harvesting and selling mutual funds prior to their annual distributions will both pull an investor out of the market and change his or her asset allocation. To avoid these risks, and something called the “wash sale” rule, one strategy is to reinvest the proceeds from the sale of every position that creates a tax loss immediately into an index fund or Exchange Traded Fund (ETF) of exactly the same asset class as the position that was sold. In this way, the investor remains fully invested, and maintains his or her asset allocation. After 31 days (to avoid the “wash sale” rule), the investor could sell the index fund or ETF and reinvest the money back into the position that was sold.

 

Lastly, before implementing either of these strategies, an investor should consider the transaction costs of making the trades, including any sales commissions that would be incurred in connection with the sale and purchase of mutual funds.

 

You should always consult with your accountant and investment adviser before taking any action.

 

Randy P. Siller is principal of Siller & Cohen, a family-wealth advisory firm in Rye Brook. He is a registered representative of Lincoln Financial Advisors Corp. Reach him at Rsiller@sillerandcohen.com.