Making Your Money Last

Harvest Tax Losses to Reap a Bounty of Savings

Despite losses in stock mutual funds, prepare for year-end taxable distributions.

By Susan B. Garland, Editor, Kiplinger's Retirement Report

November 19, 2008

EDITOR'S NOTE: This article was originally published in the October 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.

The autumn leaves are falling, and that means it's time to start making moves to trim this year's tax bill. Too often, year-end tax planning is put off until after Thanksgiving -- a treacherous procrastination given the hectic holiday season. This year, more than ever, it's important to get an early start because your efforts will be complicated by a wild card to be dealt by any mutual funds you own.

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At the top of your financial to-do list: "harvesting" capital losses to offset gains in your taxable portfolio and hold down your tax bill for the year. In this grim year for the stock market, you're probably asking: What gains? And that's where mutual funds come in.

Going into September, stock mutual funds had lost, on average, 11% for the year. But that doesn't mean the investors in those funds will report losses on their tax returns. Tom Roseen, a research manager for Lipper, a firm that specializes in mutual fund analysis, thinks 2008 may deliver a painful double whammy to mutual fund owners: double-digit losses in share value combined with massive taxable distributions to shareholders.

If that sounds like something Lewis Carroll would dream up, remember that funds are required by law to distribute to shareholders the income they earn and the profits they score each year. And, in a volatile year -- as funds sell stocks to keep up with market changes and to pay off shareholders who are bailing out of the market -- sales inside the fund can create capital gains that have to be paid out.

Roseen reports that last year funds paid out more than $580 billion in interest, dividends, and short- and long-term gains earned during 2007. Using conservative assumptions, the analyst says shareholders wound up owing Uncle Sam at least $34 billion in taxes on those payouts.

Roseen won't guess how big 2008's payouts will be. For one thing, fund managers can try to hold down distributions by doing some loss harvesting themselves -- trying to match sales of losing positions against sales that produced profits. But he concedes that most fund managers "don't give a hoot" about the tax bills faced by shareholders.

And that's why, as a fund investor, you have to give a hoot. Your personal tax-loss harvesting can bring in a bumper crop of savings. A study by First Quadrant, an investment-management firm based in Pasadena, Cal., found that investors who harvested their losses over 25 years added a median cumulative gain of 20% to their after-tax returns. The study compared regular harvesters with buy-and-hold investors in the 35% tax bracket.

Still, many investors neglect to make the most of their losers. More than 73% of households with taxable accounts ranging from $25,000 to $500,000 did not take full advantage of tax-loss harvesting, according to a study by Fidelity Investments. The researchers said inertia and reluctance to sell securities at a loss accounted for the failure to pursue this tax-saving strategy.

Your To-Do Lists

Start by making a list of every stock trade or fund redemption you've made so far this year, with a notation of the size of realized gain or loss. Then figure out what you would gain or lose on each security you currently own if you sold today. Yes, this can be a pain because you will have to dig through brokerage statements to determine your tax basis (what you paid for each investment). If you bought shares of the same stock at different times, you will need to calculate your basis for each block.

Now return to the list of your trades. You will have to know whether the gain or loss in your redeemed shares is long term or short term. If you sold something in 2008 that you've held more than a year, you will have either a long-term loss or gain, which would be taxable at up to 15%. If you sold something you've held less than a year, you will have generated either a short-term loss or gain, taxable at your ordinary income-tax rate of up to 35%.

Add your short-term losses and compare them with your short-term gains -- say, for a total of $25,000 in gains. Then match your long-term gains against your long-term losses -- say, $10,000 in losses. Then match the two against each other, for a $15,000 net gain.

Your goal is to determine what sales between now and December 31 can put you in the best tax position next April 15. To get a handle on that wild card to be dealt by your mutual funds, check the funds' Web sites or call shareholder services and ask for an estimate of the size and timing of this year's distribution. One warning: If you intend to buy mutual fund shares, wait until after the distribution date. Otherwise, you'll pay tax on any declared dividends even if you've only held the shares for a short time.

As you consider year-end sales, be aware of some rules and strategies of tax-loss harvesting.

Investment strategy should be paramount. Some clichés are worth repeating: Don't let the tax tail wag the investment dog. "Investors get too focused on taxes and sell things they should not be selling," says Mark Luscombe, principal federal tax analyst at CCH, a provider of tax information.

For instance, if you have a lot of gains, review your portfolio for the laggards you were planning to sell anyway. If you have net losses, resist the temptation to sell off winners only to take advantage of those losses. "If you were not planning to sell, what benefit would you be getting?" says Bob Scharin, senior tax analyst at Thomson Reuters, a business information group. "You should only sell if you're rebalancing or if you have too much in one particular stock or industry." Up to $3,000 of net losses can be deducted against other kinds of income and any excess can be carried over to offset gains in future years.

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