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The end of the year is the time to perform annual maintenance on your investment portfolio. You may need to shake out some of those losses that you've overlooked, or that you've been holding on to hoping for a turnaround.
April is tax time, but you definitely don't want to wait — even until the new year — to make key investment decisions. Here are three end-of-the-year tax tips to act on immediately.
Taking losses at specific times, or making sure you file specific forms if you've made changes to your retirement nest egg can save you money when Uncle Same comes calling in April.
First things first. Let's talk about losses.
End-of-Year Tax Tips #1: Tax-Loss Harvesting
Holding on to a losing stock for any reason maybe costing you more at tax time. In fact, selling these positions may save you more in the end.
It's called tax-loss harvesting. According to Investopedia, tax-loss harvesting is the selling of securities to realize a loss, which can be used to offset capital gains.
Why would you want to do that?
The maximum capital gains tax in 2009 for most people was 15%, according to the IRS.
For example, let's say you had invested $100,000 in the beginning of the year equally in two different stocks, one winner — Apple, Inc. (AAPL:NASDAQ) — and one loser — Toyota Motors Inc. (TM:NYSE). The winner handed you gains of 64% — as Apple has realized in the past 52 weeks. By only claiming the winner, you would be paying $4,800 in taxes on your $32,000 capital gain.
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Now let's say you harvested the loser.
If you had invested $ $50,000 in Toyota (just as you did with Apple) you'd have realized a loss of $3,115. That means your net capital gains would have been $28,885, and you'd be paying less than $4,333 in taxes.
It's a difference of more than $450.
"Realizing" a gain or a loss only comes after you sell or close your position. So if you end up holding on to a losing investment, you may be paying more in April…
So even though this could be a mild winter, you're still paying a bit more for your heat.
(By the way, investing doesn't have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the market with our easy-to-understand articles.)
End-of-Year Tax Tips #2: Avoid Double Taxation
We've seen a lot of people starting to take their investments into their own hands, and sometimes that means moving your 401(k) nest egg into something like an IRA, where you may have more flexibility with how you make your investments, and what you can invest in.
But in moving this money, you need to make sure you've filled out a specific form: IRS Form 8606.
If you've already paid taxes on the money you've moved from your 401(k) to your IRA, you could be taxed again on any distributions from that IRA account.
It's a classic "double dip" that can be avoided by filling out a simple form. The IRS says you should keep track of your "basis," which is the nondeductible contribution and the after-tax amount in your traditional IRA.
They won't do it for you.
End-of-Year Tax Tips #3: Beware of the Wash-Sale Rule
Let's go back to harvesting those losses for a second. Let's say you bought Toyota back in the unfortunate month of January near the top… Say, Jan. 15, at $90 a share.
By Feb. 4, 2010, Toyota shares were only trading for $72 a share… a loss of 20%. You sold before things could get too bad. But in late February, Toyota put in a bottom, and you decided to jump back in on March 3, at $76.
According to IRS rules, you cannot claim your 20% loss.
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This is the Wash-Sale Rule (from Investopedia): "An Internal Revenue Service (IRS) rule prohibiting a taxpayer from claiming a loss on the sale of an investment when the same investment was purchased within 30 days before or after the sale date. Also known as the '30-day wash-sale rule.'"
The Toyota position violated the Wash-Sale rule both ways. It was sold within 30 days for a loss, and then bought back within 30 days of the sale.
This rule was created to stop people from taking losses just so they could get a break on their capital gains taxes.
For you, that means you have to take a closer look at your positions when you're harvesting losses.
These three end-of year tax strategies will not only help clean out the cobwebs from your portfolio, but will help you save money when April 15 comes knocking.
The simple act of selling losing stocks in your portfolio can both preserve your cash and strengthen your overall portfolio.
You've got less than a month left in the year to make these changes.
Who knows? You could save hundreds, or even thousands on your next tax bill.
P.S. You know the saying, "The only certainties in life are death and taxes"? That wasn't always the case. In fact, the First Continental Congress didn't have the power to tax people's incomes, or even force states to pay taxes to a centralized government. That all came about after an elite group of wealthy — and sometimes underhanded — businessmen formed the first independent government after the American Revolution.
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