OCEAN CITY – As this extraordinarily challenging year for the economy and investment markets finally nears its end, it may be difficult to see ways to gain ground financially.
Yet, as you are adjusting your portfolio, you may be able to take advantage of an important year-end tax strategy called tax-loss harvesting. It can help offset investment losses when you are repositioning your portfolio to seize any new opportunities that can emerge during times of market turmoil.
The strategy is based on a simple concept. While the government expects investors to pay taxes on investment gains, it gives them a break when they sell their investments at a loss. For many investors, equity market losses will exceed gains for 2008, and the first $3,000 of that excess amount may be claimed as a regular tax deduction, thereby reducing ordinary income. If that amount doesn’t use up the year’s entire loss, the remaining loss can be carried forward to offset capital gains or income in future tax years.
This year, some investors—particularly owners of equity mutual funds—could be faced with unexpected tax liabilities. “A number of investors may be surprised to receive capital gains distributions this year,” said Vinay S. Navani, principal in the accounting firm Wilkin & Guttenplan in East Brunswick, N.J. “That’s because many funds have had to sell long-term holdings to raise capital to pay investors who’ve cashed out.”
That leaves fund investors in an uncomfortable position. Because of the way mutual funds are structured, profits on these transactions are passed along to shareholders, who must declare the gains on their tax returns. At the same time, however, the value of fund assets may decline, so investors who continue to hold fund shares could face tax bills as well as a shrinking portfolio.
That sting can be mitigated, though, by harvesting securities losses this year. This is done by selling securities that have taken losses. Then, where it still makes sense to invest, you can purchase securities that give you the desired investment exposure after waiting for 30 days after the original sale. That delay avoids something known as the wash-sale rule, which prevents investors from deducting losses if the same or “substantially identical” securities are bought again within a month. By banking the losses, you can offset gains when the market rebounds.
There’s also another potential advantage to this strategy: If President-elect Barack Obama makes good on his pledge to have high-income investors pay more for long-term capital gains — raising the rate at which they are taxed from 15% to 20% — those losses would become more valuable in subsequent years.
But tax-loss harvesting isn’t only about tax efficiency, nor does it represent a retreat from the market. Rather, it comes into play as part of a larger effort to rebalance your portfolio in order to obtain greater diversification. The extreme volatility of the market this year has played havoc with asset allocations, leaving many investors with an investment mix that doesn’t match their risk tolerance or long-term financial goals. For some, rebalancing is simply a matter of getting back to a sensible balance between stocks, bonds and other investments. In other cases, challenging markets have led investors to reassess their portfolios’ proportion of risks and potential returns, and tax-loss harvesting could help them reshape their investment mix to limit unwelcome surprises, especially given the likelihood of future volatility.
Doing a year-end analysis of your portfolio may reveal high-risk holdovers that performed well before the markets headed down, but may no longer make sense. Pruning some of those positions now could not only provide you with tax advantages, but also enable you to shift toward the kind of holdings Merrill Lynch Chief Investment Strategist Richard Bernstein believes may outperform in coming months. Those include high-quality bonds; stocks in “cash-flow-stable” sectors such as health care and consumer staples, and in developed international markets such as Japan; and large, domestically focused “best of breed” emerging market equities.
Investors realizing substantial losses in the current markets might also consider reducing concentrated stock positions or selling long-time holdings that have built up huge gains. In the current environment, gains on long-term holdings may be smaller, and there could be plenty of counterbalancing losses to reduce tax liability. “Investors whose portfolios have been skewed by concentrated positions can now move toward a more diversified balance,” Navani says.
Your Merrill Lynch financial advisor, working with your tax advisor, can help you take stock of your portfolio and consider year-end moves that could minimize taxes now and prepare your portfolio for better days to come.
(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)