Market Turmoil Presents Opportunities to Reap Tax Savings

By Christopher Parr

This has certainly been a challenging year for stock market investors. Over the past 12 months through the period ending Sept. 30, 2008, the total U.S. stock market was down more than 20%. The challenges stem from myriad problems including the housing debt crisis, global uncertainty over the military actions, government deficits, skyrocketing energy costs and escalating unemployment as our economy teeters into a likely recession.
No matter who is elected as the next president of the United States, it is a good bet that tax rates on investment income and capital gains may never be lower than they are in the current tax year of 2008. The recent bailout of the financial system by the federal government validates this assumption perhaps even more.
Our country simply cannot afford to continue to borrow heavily today at the expense of future long-term economic prosperity without paying the price. In other words, the first rule of Economics 101 still holds: There is no such thing as a free lunch.

Sell Losing Investments
One way to economically benefit from stock market losses is to sell some losing investments in taxable accounts. Behavioral finance professors remind us that this counterintuitive strategy is an emotionally difficult decision for many investors to make. Investors often prefer to continue to hang on to losing positions "until they bounce back." Selling a position at a loss effectively locks in that loss by converting an unrealized loss on paper to a realized loss.
By utilizing the technique of "harvesting tax losses," an investor can actually increase after-tax income by paying less tax.
This year's down market has an upside. Three advantages come to mind by selling securities that are worth less than you paid. These advantages are: reducing taxable income, pruning away unwanted securities and repositioning "tax-ugly" investments.
Offset your gains with losses. If you rebalanced your winners, such as taking some profits on energy stocks earlier this year before the gas price cool-down, you face higher taxes on these capital gains. You can offset such gains with corresponding losses. If you have, for instance, $10,000 in long-term gains and can take $10,000 in long-term losses, they will cancel each other out.

Portfolio Pruning
Prune your portfolio of investments that no longer play an important role in the structure of your total portfolio and get a tax benefit at the same time if you sell at a loss. It is important to review all of your investments periodically and understand why you hold each position. What role does each security play in your total portfolio - safety, liquidity, income, long-term growth, diversification, inflation protection?
If a particular security does not have a defined purpose in your overall plan, perhaps it is time to unload it.
The third advantage mentioned above is to remove "tax-ugly" investments from taxable accounts. "Tax-ugly" investments throw off high, non-qualified dividends that are fully taxable at ordinary income tax rates. Two examples of tax-ugly securities are corporate bonds and real estate investment trusts (REITs). The income generated by these securities is not taxed at the much lower, more favorable 15% tax rate assigned to qualified dividends from common stocks and capital gains in 2008.
Whenever possible it is best to hold tax-ugly investments in tax-deferred accounts. If you own, for instance, a losing bond fund or a REIT, you can sell it and buy a similar investment in your IRA or 401(k) plan. (See below for precautions about wash sales-a gray area here.)
Here are four points to emphasize:
1. Tax consequences are an important investment factor to consider, but not the only one, and rarely the most important factor.
2. You can't generate tax losses by selling securities held in tax-deferred accounts like 401(k) plans or IRAs.
3. You can't sell an investment at a loss and buy it back within 30 days. That will trigger "wash sale" rules that would nullify the tax loss. Replacing it with a similar but not identical security avoids that problem.
4. While losses can be used to offset gains one for one, you can only use up to $3,000 in net losses in any tax year. Any amount above that has to be carried over to the next year.
On a final note, consider saving some potential tax losses for next year. The capital gains tax rate may be higher in 2009. If the capital gains rates were to increase from 15% to 20% in 2009, your losses would become one-third more valuable.

Christopher Parr, CFP, MBA, is senior vice president and principal with Columbia-based Financial Advantage Inc. He can be reached at 410-715-9200 or cparr@FinancialAdvantageInc.com.