The end of 2014 is fast approaching. It has been a year that has generally been good for the financial markets, and many investors will celebrate by selling their stocks and spending the gains in their portfolio. The reality of all that good fortune, though, could come back to haunt them in April.
The reason: Investors will probably have capital gains, and what they should do with them isn’t always so clear-cut. Even if you own—but don’t sell—mutual funds outside of a tax-advantaged account, you might receive a capital gains distribution from them. (Most funds will make those distributions at the end of a calendar year.)
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That might sound good, but what you’ll really get is a tax bill. For 2014, investors could owe as much as 23.8 percent on any long-term capital gains they earn from mutual funds or from the sale of stocks and other securities.
There are ways, though, to minimize the tax bite. Although the tactics we list below aren’t likely to make April’s tax payments completely disappear, they might help reduce them. But you can’t wait until April to take advantage of these tax tips, as is the case with other tax-reducing moves, such as making a last-minute contribution to an IRA. You’ll have to act before the end of the year.
Harvest your capital gains. One of the most common ways to reduce taxes on capital gains is to offset stocks being sold for a gain—up to $3,000 per year—with losses from other investments you own.
In addition, there’s the opportunity to carry forward realized losses for a number of years. So, for example, if you had a loss of $12,000 after selling an investment, you could apply $3,000 of it to capital gains for 2014, as well as to gains over the next three tax years. Theoretically, if you managed to earn exactly $3,000 in capital gains each year from now through 2017, you would be in the enviable position of owing no capital gains tax in any of those years.
See more of our tax-saving advice in the Tax Center.
Reduce your adjusted gross income. This is a twofer: By making one large year-end contribution to an employer-provided retirement plan, you’re not only socking away more for your retirement but also reducing this year’s taxable income. By contributing to a 401(k) plan, you’re deferring taxes for a future period, perhaps one where you’ll be in a lower tax bracket. In the interim, your savings continue to grow, unencumbered by taxes.
The viability of that tactic might depend on the flexibility of your employer’s retirement-savings plan. Some plans let you make almost instantaneous changes to 401(k) contributions; others aren’t as flexible.
Give stocks and avoid capital gains. This is another double play. By donating stocks directly to a charitable organization, as opposed to selling them and donating the proceeds, you can avoid capital gains you might have otherwise earned. You can also deduct the market value of the stocks.
Of course, you can also donate stocks that have lost money and still claim the market value as a deduction. But you have to own the donated stocks for at least a year to take the deduction.
Watch your asset allocation. Selling or donating investments, whether for tax purposes or for other reasons, will probably have an effect on your asset allocations. So be sure to make adjustments to bring your allocations back to proportions appropriate for your long-term strategy. Often that means buying the same type of asset you just sold.
Remember, you can’t buy an identical asset—or a substantially identical one—within 30 days of a sale designed to harvest a loss without running afoul of the Internal Revenue Service’s wash-sale rule. But you can buy a similar asset. If you sell a large-cap mutual fund at a loss, for example, you can immediately use the proceeds to purchase a large-cap exchange-traded fund that may hold many of the same stocks in the fund that you just sold.
Do less. It’s a good idea, from a tax point of view, to avoid selling stocks—particularly winners—before you have to. And when you can, buy funds in which the holdings are not actively traded because that can lead to additional taxes.
Because more trading often results in more taxable events for a fund, you should consider minimizing the effects by buying index funds. They often have turnover rates of less than 10 percent annually vs. actively managed funds, which can turn over 100 percent or more of their holdings annually. Aside from their lower costs vs. actively managed funds, the lower turnover of index funds also results in greater tax efficiency.
This article also appeared in the November 2014 issue of Consumer Reports Money Adviser.
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