Year End Harvesting

As we move through December, it’s a great time to see if you can benefit from “year-end harvesting” before it’s too late.

By harvesting, I mean utilizing any unused capital losses that you’ve realized in prior years, and potentially this year, to save yourself a bundle in taxes.

As painful as realizing a capital loss is, the great news is you can recover a significant portion of your losses if handled properly.

Unfortunately, most retirees do no planning whatsoever and just pay whatever their accountant tells them to pay.

Let’s quickly review capital gains tax law for a moment so we can clarify where this opportunity lies for you.

Capital Gains Tax Law

As a refresher, for investments you currently own outside of IRAs (you don’t pay capital gains when you buy and sell investments inside your IRA), all “realized” gains are taxed at capital gains tax rates.

For example, if you purchased a stock or stock mutual fund for $50,000 and later sold it for $75,000, you would owe capital gains taxes on the growth, i.e. $25,000.

On the flip side, however, if you purchased a stock or stock mutual fund for $50,000 and later sold it for $40,000, you can declare a capital loss of $10,000.

That $10,000 capital loss, while painful to realize, has significant value if handled properly. For example:

  1. You may use it to offset $10,000 of capital gains you realized in the same year, thus eliminating taxes on $10,000 of capital gains. This saves the average taxpayer a minimum of $1,500 in federal taxes, not to mention state taxes here in Massachusetts.
  2. If you don’t have $10,000 of capital gains to offset, you can use $3,000 of the loss to offset $3,000 of ordinary income you have this year. That would save the average taxpayer approximately $750.
  3. You can then carry the unused portion ($7,000) over to next year and continue the same strategy. If you have a $7,000 gain next year, you can offset the entire tax due. If not, you can offset another $3,000 of ordinary income tax and carry the remaining $4,000 over to the following year.

Opportunity

Had you sold any investments during the downturn in 2008/2009, thus locking in and ‘realizing’ a capital loss, you now have the opportunity to recover some of your losses.

Or, if you have any investments held outside of IRAs that are currently in the red since you purchased them, you have an opportunity to lock in a capital loss right now and use it against your realized gains this year.

Mutual Funds Held Outside of IRAs

Even more important, however, are stock mutual funds you own outside of IRAs.

By law, mutual funds must pass on all realized gains to their shareholders at the close of each year.

If you’ve owned stock mutual funds for several years, you know what I’m referring to. You may have had to pay significant taxes in the past, even if you didn’t sell any funds!

You receive a 1099 in the mail from the mutual fund company informing you that you have thousands of dollars of capital gains that you must report to the IRS, even though you didn’t make any sales.

This event is likely to occur with many equity funds this year.

The good news for you is that you can now put those painful capital losses from back in 2008/2009 to work for you to save yourself a bunch of taxes.

Strategy

My recommendation for you is three-fold:

  1. Pull out your 2010 federal income tax return. Take a look at the bottom of Schedule D to determine if you have any unused capital losses carrying forward into this year. And, if so, how much?
  2. Take a look at your realized and unrealized gain/loss positions in your non-IRA account statements.
    1. Have you already realized some gains in 2011 that you’ll want to offset with losses you carried forward from 2008 or 2009?
    2. Do you have any stocks or stock mutual funds that you’ve thought about selling, but haven’t pulled the trigger because it will carry a large capital gains tax with it?
  3. If you own stock mutual funds, go to your fund company(s) website and you will typically find year-end “internal” capital gains distribution estimates. Do your best to determine what your short and long term gains will look like.

Once you’re armed with this information, look for opportunities to offset this year’s gains with either prior losses you’ve carried forward, or with losses you could “realize” this year by selling specific holdings.

Harvesting is a critical year end strategy which you can’t afford to let pass you by. The difference could be thousands of dollars of tax savings in April.