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Tax Strategies for Today's Uncertain Market

Nobody except hard-core short sellers can be very happy about the stock market’s performance in the last year or so. That said, we have a bit of good news. The market’s return to earth opens up some nice tax-saving opportunities that you may be able to take advantage of. When you think about it, reducing your tax bill is just as good as making money in the market. In fact it’s almost better, because you won’t owe taxes on the extra dough you’ll find in your pocket. So here is our short list of tax-smart strategies that work during periods of difficult stock market conditions.

Reorganize Your Investment Portfolio and Cut Taxes Too

As you probably know, the maximum tax rate on long-term capital gains is generally only 20%, which is pretty good. However zero percent is even better. And zero percent may be all you’ll owe if you see this as a good time to reshuffle your investment portfolio. Let’s assume that the reshuffling process involves selling some winners (current market value above what you paid). The tax-saving strategy is to follow up by selling enough losers (currently worth less than what you paid) to fully offset the gains from the winners. Result: you owe zero to Uncle Sam.

But why stop there? You can continue trimming more losers from your portfolio until you’ve generated a $3,000 net capital loss for the year ($1,500 net loss if you’re married, but file separately from your spouse this year). You can then deduct that $3,000 loss against 2001 taxable income earned from any other source (salary, self-employment activities, interest, dividends, alimony, etc.). This is what Wall Street types call "harvesting your losses," which is a nice way to put it.

If your harvesting activity triggers a net capital loss above the deductible limit ($3,000 or $1,500), you are allowed to carry over the excess loss to 2002. You can then use the carryover loss to either shelter future capital gains or income from other sources, according to the rules just explained.

But what if you already have a large net capital loss from your year-to-date sales? In this situation, consider selling just enough winners to climb back up to that magic negative $3,000 (or $1,500) level. Locking in those gains by selling the securities won’t add anything to your 2001 tax bill.

Use "Specific ID Method" to Further Minimize Taxes

Say you want to unload only some of your shares in a particular company or mutual fund. For example, you might want to sell part of your Microsoft holdings, while still hanging onto a reduced stake. If you acquired the Microsoft shares at various times for various prices, your tax-saving objective here is to sell the highest-cost shares first. That way, you’ll trigger the lowest possible capital gain or the biggest possible capital loss.

Under the so-called specific ID method, you can select the particular shares you wish to sell (the highest-cost ones). To take advantage of this tax-saving method if your securities are held by your broker, IRS regulations say you must notify your broker regarding which shares you want to sell and identify them by reference to their purchase date and per-share price. The broker must then issue you a written confirmation of your instructions.

Unfortunately, discount and online brokers may be unwilling or unable to issue these confirmations. In this scenario, the Tax Court’s 1994 Concord Instruments Corp. decision seems to say you can give oral instructions regarding which shares to sell and still use the specific ID method even though no confirmation is forthcoming. However, you should carefully document your instructions by making notations on the written transaction statements received from your broker (and it is still better to follow the requirements under the IRS regulations when possible).

Sell Winners from Retirement Accounts—Losers from Taxable Accounts

It may be impossible to fully offset your gains from selling winners with losses from selling losers. In other words, you just did too good a job of picking the right stocks to own. However, as you now adjust your portfolio by selling a bunch of winners, you may still be able to avoid paying taxes. Do this: try to sell winners mainly from your tax-advantaged retirement accounts (traditional and Roth IRAs, 401(k)s, variable annuity account, etc.). Sell losers mainly from your taxable brokerage accounts.

That way you can cash in your profits without paying Uncle Sam for the privilege. In fact, if you generate a net capital loss from taxable account sales, you can still shelter up to $3,000 (or $1,500) worth of income from other sources, as explained earlier.

Sell Losers and Donate the Cash; but Give Winners Away

Say you want to make some gifts to your favorite relatives or charities. In fact, you can make these gifts in conjunction with your overall program of reducing the amount invested in stocks. Here’s how to get the best tax results from your generosity.

First, don’t give away loser stocks (currently worth less than what you paid) as a gift to a relative. Instead sell the shares and take advantage of the resulting capital loss to shelter your capital gains or income from other sources, as explained above. Then give cash to your relative. Since you just sold the stock, you’ll have the cash on hand.

Second, do give away appreciated shares to children or grandchildren who are in the 10% or 15% tax bracket. When they sell, the resulting gains will be taxed at only 10%, provided you and the gift recipient have together owned the stock over a year. If your combined ownership period is more than five years, the tax rate drops to only 8%. Wow! Even if the shares have been held for only one year or less, the gift recipient will still pay at most a 15% tax on the gain. That’s still a pretty good rate. In contrast, if you sell appreciated stock yourself, you’ll probably pay 20% on any long-term gains. Short-term gains will be taxed at your regular rate, which can be as high as 39.1% this year.

However, watch out for one thing before you employ this give-away-appreciated-stock strategy. Gains recognized by children under age 14 may be taxed at their parents’ marginal rates under the so-called Kiddie Tax rules. Usually that means the child will pay more than the mere 8%, 10%, or 15% rate you expected when you made the gift. Fortunately, the Kiddie Tax doesn’t apply the year a child turns 14, or any years thereafter. Also, the Kiddie Tax only affects children with over $1,500 of "unearned income" from capital gains, interest, dividends, and the like.

Now let’s talk about charitable donations. It turns out the strategies for gifts to relatives work equally well for gifts to charities. So, sell loser shares and claim the resulting tax-saving capital losses on your return (subject to the loss deduction limits discussed earlier). Then, give cash to the charity and claim the resulting charitable write-off. As you can see, this idea results in a double tax benefit for you.

As for winner stocks, give them away to charity instead of donating cash. Here’s why. For publicly traded shares you’ve owned for more than one year, you’re allowed to claim a charitable deduction for the full current market value. Plus, when you give the appreciated stock away, you get rid of the "built-in" capital gains tax liability. So this idea is also a double tax-saver for you. Because the charitable organization is tax-exempt, it can sell your donated shares without owing anything to Uncle Sam. Truly, this is a win-win situation for everybody except the IRS.

Consider Converting Your Traditional IRA into a Roth

Back in 1998, lots of people took advantage of the opportunity to convert traditional tax-deferred IRAs into permanently tax-free Roth IRAs. A conversion is treated as a taxable liquidation of the traditional IRA. For 1998 only, you were allowed to spread the tax hit over four years. While the four-year-spread deal is no longer available, converting your traditional IRA into a Roth account right now might still be a really good idea.

Here’s the best scenario. Your traditional IRA is (or was) loaded with equities and took a major beating during the stock market downturn. So your account is now worth a lot less than it once was. Correspondingly, the tax hit from converting your account into a Roth IRA right now would also be a lot less than before. After a conversion, all the subsequent income and gains earned in your Roth account will be totally free of any federal taxes, assuming you meet the basic qualification rules.

Of course conversion is not a no-brainer. You have to be satisfied that paying the up-front conversion tax bill makes sense in your circumstances. In particular, converting a big account all at once could push you into higher 2001 tax brackets, which might not be good. You must also make assumptions about future tax rates, how long you will leave the account untouched, the rate of return earned on your Roth account investments, and so forth. Remember: to be eligible for a Roth conversion this year, your 2001 adjusted gross income (AGI) cannot exceed $100,000. If the conversion idea intrigues you, please contact us for a full analysis of all the relevant considerations and for suggestions on how to keep your AGI below the $100,000 limit.

Conclusion

So now you know about some tax-saving moves that are especially relevant during a down stock market. With the major tax law changes we’ve seen this year, there are plenty of other issues to think about as well, especially as year-end approaches. Please give us a call if you have any questions or want more details about the strategies covered in this letter. Naturally, we are always available to discuss 2001 tax planning in general, or anything else you would like to talk about.