Using Your Lemons To Reduce Your 2010 Taxes

Do you remember what you were thinking just two short years ago in December 2008?

You may recall that we were right smack in the middle of one of the sharpest stock market declines in history.

It was not exactly what we’d call a “fun” time.

Enduring that stock market tumble was challenging to say the least.  Painful would probably be a better word.

Witnessing the value of your investments drop is no fun for anyone, especially when you’re at the stage in your life where you’re dependent on your savings to support your lifestyle.

Looking back now, however, it’s amazing how time heals most wounds!

While we’re not exactly experiencing a smooth recovery, asset prices have climbed significantly higher over the last two years.

During that tumultuous time at the end of 2008, we talked about an opportunity which I dubbed, “turning your lemons into lemonade”.

Where that opportunity existed was in capital gains tax law.  Let’s quickly take a look back for a moment.

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 $15,000 and later sold it for $25,000, you would owe capital gains taxes on the growth, i.e. $10,000.

On the flip side, however, if you purchased a stock or stock mutual fund for $25,000 and later sold it for $15,000, 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.

Opportunities

Had you turned some of your “lemons” into lemonade back in 2008, thus locking in some realized capital losses, you’re going to be a very happy camper in 2010 and 2011.

The reason for this is that prices have now climbed significantly.  If you sell a stock or stock mutual fund this year or next, it’s highly likely that you’re going to do so at a gain.

If you carried forward your unused realized capital losses from back in 2008, you can now use those losses to offset the taxes now due on the gains from sales in 2010 and 2011!

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 most equity funds at the close of 2010.

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

Strategy

My recommendation for you is three-fold:

  1. Pull out your 2009 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 2010 that you’ll want to offset with losses you carried forward from 2008?
    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.

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

Committed To Your Relaxing Retirement,

Jack Phelps

The Retirement Coach

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