Use the IRS to Ease the Bear's Big Bite

Even for many of the nation's most sophisticated investors, this has been an unusually painful year. But there are valuable tax-saving strategies to consider that may help ease the sting.

As painful as it is to lose money, investment losses can reduce taxes significantly. For example, many investors can benefit by using a technique known as "tax-loss harvesting," or selling losers in order to offset gains on their winners -- and, in some cases, regular income, too.

To be sure, never make any investment move exclusively for tax reasons, don't let the tail wag the dog. But don't make important investment moves without at least considering the tax implications.

Here's a primer on the capital-gains rules.

The Basics

Investors can offset capital losses against gains on a dollar-for-dollar basis, with no upper limit. Suppose you sold a stock early this year that you purchased years ago, and your profit was $5,000. Now, you sell another stock for $5,000 less than you originally paid for it. Put the two together, and your net gain is zero. That means no capital-gains tax on your earlier gain.

Now suppose you have capital losses but little or no gains. If your losses are bigger than your gains, or if you don't have any gains, you typically can deduct as much as $3,000 of your net losses from your other income, such as wages, dividends and interest. (The limit is $1,500 if you're married and filing separately from your spouse.) Additional loss amounts are carried over into future years. Thus, if you were thinking of a selling a loser anyway, this could be a good time to pull the trigger.

These rules once prompted a memorable query from a reader. He had amassed $2.1 million of stock-market losses and was searching for a woman with large capital gains who would be interested in marriage. "My broker tells me it is not necessary to live together, and a divorce can be had after the tax loss is used up," he wrote.

Some investors assume there is only one capital-gains tax rate: 15%. Wrong.
The rate can depend on several factors. If you sell a stock or mutual fund you've owned for a year or less, that's considered a short-term gain, and it's typically subject to tax at higher ordinary income-tax rates.

Under a provision that became effective Jan. 1, investors in the two lowest ordinary income-tax brackets may qualify for a long-term capital-gains rate of zero. (Tax-preparation software can help you figure this out.) Separately, the top rate on long-term gains from art and collectibles is 28%.

If you're planning to make a gift of stock to your favorite charity, pick your holdings with long-term gains (investments you've held for more than one year). If you itemize your deductions, you typically can deduct the stock's fair market value -- and you won't owe capital-gains tax on the appreciation.

But don't donate a stock that's dropped in value.Instead, consider selling it, use the loss to save taxes, and donate the proceeds to your favorite charity.

Wishing you many happy returns,

Dr. Wayne T. Essex