Smart Year End Tax Moves

Cutting your tax bill by selling your losers could sweeten an otherwise sour year for investments.

By Mary Beth Franklin, Senior Editor

From Kiplinger's Personal Finance magazine, December 2008

The past year's market rout has probably left you with some real dogs in your investment portfolio. But every dog has its day. By unloading some of your losers by year-end, you can still savor the satisfaction of trimming your 2008 tax bill next spring. "Years like this offer the greatest opportunity to offset current or future capital gains or other income," says Josh Willard, senior vice-president of the Coghlan Financial Group, in San Diego.

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You must first use your capital losses to offset any capital gains. After that, you can apply your losses to offset up to $3,000 of ordinary income in 2008. This strategy is particularly valuable because wages and interest income are taxed as high as 35%, compared with a maximum 15% rate on long-term capital gains (profits from the sale of investments that you owned for more than a year) and qualified dividends. Investment losses that you can't use to offset capital gains or income may be carried over for future tax years, which could come in handy when the market rebounds. Caveat: This strategy applies only to your taxable accounts, not to retirement accounts.

Zero Capital Gains

Some investors will be able to capture tax-free profits without harvesting losses, thanks to a new provision that allows people in the two lowest income-tax brackets to pay nothing on long-term capital gains in 2008. The 0% capital-gains rate applies to married couples with taxable incomes of $65,100 or less; single heads of households with taxable incomes of $43,650 or less; and individuals with taxable incomes of $32,550 or less.

Your taxable income is the amount left over after you deduct your personal exemptions -- worth $3,500 apiece in 2008 for you, your spouse and each dependent -- as well as your standardized or itemized deductions. "Because this tax break is tied to taxable income, not adjusted gross income, making year-end charitable contributions or otherwise increasing itemized deductions can raise your eligibility for tax-free capital gains," says Bob Scharin, senior tax analyst for Thomson Reuters.

The tax-free capital-gains break is scheduled to continue through 2010. But with a new president and Congress facing a growing federal budget deficit next year, current tax laws could be modified. If you qualify, grab this tax break while you can.

Taxpayers who have some cash-flow flexibility stand to benefit the most. That includes retirees who are not yet required to take annual distributions from their retirement accounts, as well as anyone who can take substantial deductions, such as small-business owners, says Bob Cassel, director of tax services for Baltimore Washington Financial Advisors, in Columbia, Md.

One of Cassel's clients, an early retiree from Addison, Pa., plans to cash in about $40,000 worth of capital gains tax-free this year. Joe Garber relies solely on his IBM pension and investment income. After claiming substantial deductions for mortgage interest and state and local taxes, he and his wife, Jean, should be able to hold their taxable income well below the $65,100 limit. "When Bob told me about it, I was really excited," says Joe, 52. "I'm one happy camper." Any gains that lift the Garbers' income above the $65,100 threshold would be taxed at the regular 15% capital-gains rate.

If your income is too high to qualify, you may still be able to benefit from the tax-free capital-gains treatment by transferring appreciated securities to lower-income family members, such as adult children and elderly parents. As long as you owned the asset for more than one year, the recipient of your gift assumes your holding period and can sell the asset tax-free. But, Cassel warns, don't run afoul of the newly expanded kiddie-tax rules, which now apply to children younger than 19 and full-time college students younger than 24. Investment income that dependent children receive in excess of $1,800 this year will be taxed at your higher rate, not the zero capital-gains rate.

Down-to-the-Wire Deals

Many older taxpayers, such as Mary Mellon of Arlington, Va., were relieved when Congress revived last year's tax break that allowed IRA owners 70 and older to donate up to $100,000 from their retirement account directly to a charity and avoid paying income tax on the distribution. The IRA provision, extended through 2009, was part of the $700-billion economic rescue package. Last year, Mellon, 72, donated her entire required distribution to little-known medical charities that perform pro bono surgeries around the world, and she'll do so again this year. "They do a lot of good work, but they aren't as well known or as well funded as the Red Cross," she says.

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