How Shrewd Investors Save on Taxes

This article is courtesy of Marotta Asset Management and discusses saving on taxes by giving appreciated stock. I do this, as I've detailed in A Great Way to Change Your Portfolio.

When you're building wealth, saving a penny on your taxes is just as important as earning a penny in the markets. You can use both investment losses and investment gains to good tax advantage.

For example, in November some U.S. stocks experienced a significant drop. Disciplined investors use these declines to save on their taxes and rebalance their portfolios.

But most people are loss averse. Selling an investment for a loss feels like failure. So they hold on and wait for it to come back up before they sell. It doesn't matter if another investment might appreciate faster and recover the loss more quickly. Their reluctance to sell is even more pronounced when the investment was purchased recently. In taxable accounts, however, investors must overcome this loss aversion and learn to realize capital losses whenever possible.

The stock market normally appreciates over 10% each year. Any investment you hold for a few years will probably have a satisfying capital gain. The only investments you are likely to be able to sell for a loss and deduct on your taxes are recent purchases. Be quick to sell your capital losses in taxable accounts and reinvest the money at a lower cost basis going forward.

The difference between what you paid for an investment and its current worth is called a "capital gain" or a "capital loss." As long as you continue to hold the investment, the gain or loss is "unrealized." Selling the investment means "realizing" the gain or loss, which you must report on your taxes.

Realized capital gains are commonly taxed at a reduced 15%. Realized losses can offset realized gains, but you are also allowed to deduct up to $3,000 of capital losses against other types of income. If you have net losses in excess of $3,000 in one year, you can carry your losses forward to future years.

Now is a good time to review your portfolio for investments you can sell for a loss. Use software to track your investments. Even a simple spreadsheet can compute the current value minus the cost basis of each investment. Consider any significant losses for tax-loss selling.

Ask yourself, "If I did not own that security now, would I buy it at current prices?" If the answer is no, sell. If the answer is yes, sell it anyway. Then wait 31 days and buy it back. That way you "realize" the loss for tax purposes and still hold the security. And you have reduced your tax liability by sharing that loss with Uncle Sam.

Another technique is to double up. First, purchase the same number of shares you currently hold in that security. Wait 31 days. Then sell the original shares for a tax loss. Waiting a month between the sale and the buyback avoids a "wash sale," which would prevent you from taking the tax loss.

Most investments (stocks, bonds, mutual funds) are subject to the same tax rules, but owning individual stocks provides additional tax-loss selling opportunities.

Compare two millionaire investors. The first buys $1 million of a mutual fund that invests in 200 different stocks. No stock represents more than $10,000 of the investment, and the amount invested in each stock is $5,000. Although the mutual fund might have a tame 10% return for the year, one of the underlying stocks in the fund might have doubled and two others lost 50% of their value during the year. But this investor only owns shares in the mutual fund, and he cannot take advantage of any tax-loss selling.

The second millionaire buys all 200 as individual stocks. Her overall portfolio also has a tame 10% annual return, but she has additional choices that help boost her earnings even higher. She can sell the two stocks that have a 50% negative return and take the loss on her taxes. By selling the stocks with losses, she realizes their loss for tax purposes. By not selling her stocks with gains, she avoids realizing those gains and therefore is not required to pay any capital gains taxes.

Selling investments with losses can reduce your taxes, but you can also save on investments that have gone up by using appreciated assets for your charitable gifting.

Many Americans donate to charities in December. No matter what worthy organizations you support, you can contribute up to 15% more if you give appreciated investments instead of cash.

For example, if you sell $1,000 worth of appreciated stock, you most often pay capital gains tax of 15%. If most of the stock's value is appreciation, the tax burden approaches $150, leaving only $850 for charitable giving.

But if you give the stock directly to the charitable organization, you can take the full $1,000 tax deduction, and the organization will not have to pay any taxes when it sells the stock. You could save up to $150 on capital gains taxes, and the gift itself reduces your taxes at your marginal rate. In total, your $1,000 gift could cost you $500 or less if you use appreciated stock!

Here's how to do it:

1. Ask your financial advisor to choose which stocks are best for charitable giving (probably those that have appreciated the most and you do not want to continue holding in your portfolio).

2. Determine the amount of each charitable contribution. To compute how many shares of stock to give to each charity, divide the current price of the stock into the amount you wish to donate. The number of shares will not work out exactly, so you may need to round up or down.

3. Call the designated charities and ask for their "stock liquidation brokerage account." Nearly every organization has one expressly for this purpose. You may like to give anonymously and without fanfare, but you only have to request this account number once.

4. Instruct your brokerage firm to transfer the correct number of shares from your account into the charity's stock liquidation account. You can fax this request directly and then send the original by mail.

5. Save these letters and account numbers for next year's charitable giving.

6. Report the gifts to your tax accountant. Stock gifting is deductible at the fair market value, that is, the amount the stock was worth at the close of the day it was transferred. The stock may change value after you have transferred the stock but before the charitable organization sells it. These changes do not affect your tax deduction, but it may mean the charity reports a different amount than you must declare on your tax return.

Giving appreciated stock is a great way both to reduce your taxes and to give more generously to worthy charities.

Comments

Any unwanted stock will be greatly appreciated here.