A sound investment plan looks for tax saving ideas year round, but the end of the year is when many U.S. investors begin thinking about the upcoming April tax filing deadline. Ordinary investment accounts, IRAs, qualified retirement accounts, and estate assets all offer opportunities to reduce the current year’s taxes and trim future federal income tax liability as well.
Investment Tax Tips
Investors with unrealized capital gains are often reluctant to sell their profitable positions, preferring to delay the capital gains tax as long as possible. However, doing so for long periods can result in lopsided portfolios with too much exposure to one particular stock or asset class. A better approach is to rebalance the portfolio at least annually, which can mean selling some of the “winners” and using the profits to increase positions among the “losers” at lower prices.
In its simplest form, this approach would almost certainly result in capital gains tax exposure. However, there is a way to offset some of the gains by selling some of the losing positions as well. The resulting capital losses can be used to negate some or all of the capital gains generated from sale of the appreciated positions, yielding a source of tax free income for the investor.
However, the subsequent loss sale now leaves too much cash sitting idly in the portfolio. Having sold off a portion of the portfolio, the investor still needs to reinvest the tax neutralized gains in more shares of the under appreciated asset classes. The Internal Revenue Service (IRS) has rules against selling a stock at a loss and then repurchasing shares of the same stock within 30 days, a technique referred to as a “wash sale.”
Investors can avoid running afoul of the wash sale rule by reinvesting their cash into similar, yet different stocks or mutual funds. As long as the new purchase is a different company’s stock or fund company, even though the asset class or investment style is the same, the wash sale rule remains unbroken. IRS Publication 550, Investment Income and Expenses, contains more information regarding the IRS rules for capital gains and losses.
Reduce Federal Taxes with Retirement Contributions
Due to the tax-deferred nature of individual retirement accounts (IRAs), 401(k) plans, and similar qualified retirement accounts, managing capital gains tax is not an issue when rebalancing these assets. Despite their lack of capital gains offset opportunities, retirement accounts can still play a role in reducing income taxes.
Contributions to company retirement plans are generally made with pre-tax dollars, which reduces the participating employee’s current taxable income. Those who are not already contributing the maximum annual allowable amount to these plans can immediately reduce their income tax by increasing their retirement plan contributions.
Retirement plan participants and IRA owners who are age 50 or older can also benefit from a so-called “catch up” provision in the U.S. Tax Code. Investors in this age demographic are allowed to make an extra annual catch-up contribution of $1,000 above the $5,000 annual 2009 and 2010 contribution limits for IRAs. The catch-up contribution limit for 401(k) participants age 50 and older is $5,500 above the usual $16,500 maximum 401(k) contribution limit.
Current U.S. tax provisions allow for a great deal of flexibility when managing the taxable aspects of investment and retirement accounts. Savvy investors can enjoy an easier time filing tax returns by taking prudent steps at year-end and throughout the year to reduce their overall tax liability. As always, it is advisable to seek the advice of a tax professional before engaging in any tax planning strategy.
