Year-end tax planning and retirement accounts Featured

8:00pm EDT October 26, 2010

As the economy continues to limp toward recovery, many people are finding that their investment portfolios are a mixed bag of gains and losses. As year-end approaches, it’s smart to review your situation and consider strategies that can minimize capital gains tax and use capital losses to your tax advantage.

“Too many investors sit on their portfolios because of uncertainty on how to handle tax issues,” says Curtis Campbell, partner, Tax Services department at HMWC CPAs & Business Advisors in Tustin. “Yet if they knew what to do it could make a significant impact on their tax situation.”

Smart Business spoke to Campbell about how to approach year-end tax planning to your advantage.

How should I handle capital gains and losses?

Investors typically know that they can offset capital gains with capital losses. Depending on the individual’s investment portfolio, there might be fairly substantial losses that are still present, due to the volatility in the market. If your losses exceed your gains, you can offset the excess against up to $3,000 in ordinary income (with unused losses carried forward to future years).

Net short-term gains are taxed as ordinary income, while net long-term gains enjoy a lower tax rate — generally 15 percent for taxpayers in the middle and higher brackets. But as of this writing that rate is scheduled to increase to 20 percent in 2011 if Congress doesn’t take action. If as year-end approaches it looks like rates will indeed go up next year, you might want to sell appreciated investments by December 31 to take advantage of the 15 percent rate. But if you have a net gain for the year and want to reduce your 2010 tax bill, consider selling underperforming investments to generate losses to absorb the gain. Your tax advisor can prepare an analysis to help in determining the appropriate move.

For example, let’s say that your portfolio includes $20,000 of a technology stock that you paid only $10,000 for. You’d like to sell it to diversify your portfolio, but you’re concerned about the capital gains tax. You also have $5,000 of an auto industry stock that you paid $15,000 for. You’re thinking about selling both stocks so your $10,000 loss on the auto stock can offset your $10,000 gain on the tech stock. But you may want to think twice. If you have more capital gains to recognize next year, you could be better off holding on to the auto stock and paying capital gains tax on the tech stock sale. Why? The tech stock gain will be taxed at 15 percent, so offsetting it with the auto stock loss will save you $1,500. But if you wait until Jan. 1 to sell the auto stock and use it to offset a $10,000 gain next year and your capital gains rate is 20 percent, it will save you $2,000 in taxes. (The figures presume that the share prices stay the same regardless of whether the sale is in 2010 or 2011.)

What if I still have high hopes for a poor-performing investment?

One option is to sell the investment at a loss to generate tax benefits and then reinvest to keep your portfolio intact. For this strategy to work, you must beware of the wash sale rule, which prohibits a loss deduction if you acquire substantially the same security within 30 days before or after the sale. To avoid a wash sale, you can (1) sell the investment at a loss and wait 31 days to reinvest, or (2) buy replacement securities first and wait 31 days to sell the original investment. Either way, you assume the risk of price fluctuations during the 30-day waiting period.

Can I use losses on stocks, bonds or mutual funds held in IRAs, 401(k) plans or other retirement accounts to generate tax benefits?

Unfortunately, in most cases, the answer is no. Traditional IRAs and employer-sponsored plans generally are funded with pretax dollars. Even if they’ve suffered substantial losses, if you sell the investments and close the account, the amount you withdraw will be treated as taxable ordinary income.

You may, however, be able to deduct losses in a Roth IRA, traditional IRA or employer plan if you’ve built up a sufficient tax basis through nondeductible contributions. Suppose, for example, that you’ve made $30,000 in nondeductible contributions to a traditional IRA, but the IRA’s current value is only $20,000. If you close the IRA, you’ll realize a $10,000 loss.

The loss has limited value, though. To deduct the loss you’ll be required to close any other traditional IRAs you own. Plus, the loss can be deducted only as a miscellaneous itemized deduction. Such deductions are subject to a 2 percent of adjusted gross income (AGI) floor, so you’ll enjoy a tax benefit only if your total miscellaneous deductions exceed 2 percent of your AGI.

For a traditional IRA that has lost value, consider converting it to a Roth IRA. Doing the conversion while the IRA’s value is depressed can minimize the tax hit. Plus, if you convert in 2010, you can defer the income and report half on your 2011 return and the other half on your 2012 return.

Are taxes the major consideration?

Investment decisions should never be based on taxes alone. But taking taxes into account in your planning can help improve your after-tax return. Numerous factors must be considered before making an investment decision, including your goals, time horizon and risk tolerance, plus various factors related to the investment itself. Tax considerations are also important, but they shouldn’t be the primary driver of investment decisions. Still, with rates potentially increasing next year, taxes may take a more prominent role.

Check with your tax advisor for the latest information on all time-sensitive facts in this article.

Curtis Campbell is partner-in-charge of the Tax Services department at HMWC CPAs & Business Advisors in Tustin. Contact him at (714) 505-9000 or