Year-end tax planning for investors.
Bonds drop back
The bond market has retreated in 2013, so you might have losses on individual bonds and bond funds. Especially for upper income investors, taking losses on bonds by year-end might save tax.
Example 1: Doug Harris has taxable income over $450,000 in 2013. Consequently, he faces a 20% tax rate on long-term capital gains in 2013. Doug also will owe a 3.8% surtax on net investment income, under the Affordable Care Act. Counting state income tax as well as a phaseout of itemized deductions and personal exemptions, Doug might owe 30% in tax on long-term capital gains.
In December, Doug tallies his capital gains and losses for the year so far; he also contacts his mutual funds to ask about expected capital gains distribution in 2013. Counting his net long-term capital gains in 2013 and expected mutual fund distributions, Doug anticipates reporting $40,000 of gains for the year, so he could owe $12,000 in tax on those gains at an effective 30% rate.
Instead, Doug sells enough investments to incur $50,000 worth of losses by year-end 2013. Now, he has a $10,000 net loss to report for the year. Under the tax code, Doug can deduct up to $3,000 worth of net capital losses for the year. Instead of owing $12,000 on net gains, Doug has a $3,000 loss.
Doug's loss will reduce his taxable income, which is taxed at a combined federal and state marginal rate of more than 40%. Thus, a reported $3,000 net capital loss will save Doug more than $1,200 of income tax, altogether, when he files his 2013 return next year. After deducting $3,000 for 2013, Doug will have a $7,000 remaining net capital loss that he can carry over to future years.
Watch out for wash sales
To take his capital losses, Doug Harris sold securities. He wants to reinvest the money he received. However, if Doug immediately repurchases the same securities he sold, or if he buys securities that are substantially identical, he won't be able to deduct the capital losses on his 2013 tax return.
In order to avoid a so-called "wash sale," Doug has a few options. He can hold the money in cash for at least 31 days. Then Doug can buy anything he wants, including the securities he sold for a loss.
As another alternative, Doug can reinvest right away, as long as he avoids purchasing the assets he sold at a loss. If Doug sold a long-term bond fund from one company at a loss, he can immediately buy a long-term bond fund from a different company. As long as the second fund does not hold the same bonds as the first fund, Doug won't have a wash sale.
Swap and shop
In a year when bonds have lost value, such as 2013, bond swapping emerges as a viable strategy. A bond swap is not a trade, like an exchange of baseball cards. In a bond swap, an investor sells bonds and buys similar bonds.
Example 2: Linda Powers holds $100,000 worth of municipal bonds that she bought 4 years ago at par. The bonds mature in 15 years, they have an A rating, and the coupon rate is 6%. Those bonds are now worth $90,000.
Linda sells those bonds and uses the $90,000 to buy municipal bonds from a different issuer. The new bonds, which mature in 15 years, also have an A rating and a 6% coupon. Thus, Linda gets a $10,000 capital loss, for tax purposes, yet her portfolio is essentially unchanged. Typically, if you acquire a bond with a different issuer, maturity, or coupon rate, your bond swap won't be considered a wash sale.
As explained, you may be able to reap tax advantages by selling securities at a loss. In other situations, you might save tax by selling securities at a gain; that's because ATRA made the 0% tax rate a permanent part of the Internal Revenue Code. In 2013, income from qualified dividends and long-term capital gains are taxed at 0%, for certain taxpayers. To get that 0%, you must be a single taxpayer with taxable income (after deductions) no higher than $36,250, or up to $72,500 on a joint return.
Example 3: Matt Allen bought shares in a stock fund in 2009 for $20,000. Those shares are now worth $35,000, and Matt fears a market correction. If he sells those shares, he would owe 15% on the long-term capital gain; Matt's modified adjusted gross income (MAGI) is over $200,000, so he also will owe the 3.8% Medicare surtax.
Instead, Matt gives the shares to his retired parents, who generally report about $50,000 of taxable income on their tax return. The senior Allens sell the shares and owe no tax on the $15,000 gain because their taxable income is still below $72,500 for the year.