We are all very busy these days, with many of us working twice as hard for half the money (at least it seems that way to me). However, this is an important and opportune time to review some of our tax planning strategies. In this week’s column I will highlight a few of the most useful tips to help you take advantage of opportunities, or possibly avoid some pitfalls.
First, with the stock market gains that we have experienced this year, many have paper profits—gains in their investments that have not been realized as of yet by selling the position. It is quite common for the stock market to sell-off in January, especially after a positive year. Many investors would prefer to sell their stocks in December to lock-in their profits, but do not want to assume the tax liability on their capital gains for the current tax year. If only there was a way to sell in December, but put-off the tax recognition for the capital gain until the following tax year.
Prior to 1997, we could “selling short against the box.” In essence, we would do would be to sell the stock short in our account, even though we actually own the stock (shorting stock normally involves borrowing shares we do not own from someone else, depositing these borrowed shares into our account, and then selling them). What results when we sell short against the box is that we still own the original shares in our account, but we also have a short position in our account for the same number of shares that we actually own. Both positions—the long position we already owned, and the short position—are in the account at the same time. We hold both positions until after the first of the year, at which time the transactions are closed out—the long position is crossed with the short position, and the investor gets to defer the tax liability on the capital gains until the following tax year.
Unfortunately, the Tax Relief Act of 1997 removed the tax benefit of selling short against the box, so we can’t do that anymore. (There does appear to be a small loophole in the 1997 revisions that permit shorting against the box to delay a taxable event. If you have a short against the box position and then buy-in the short within 30 days of the start of the tax year, and then leave the long position at risk for at least 60 days before offsetting it again, the constructive sales rules do not apply. So it appears that you can continue shorting against the box to defer gains, but you have to temporarily cover the short and be exposed for at least 60 days at the beginning of each and every year. Investors should consult their tax advisor before employing this strategy.)
One thing we can do to protect our profits is to purchase put options on our long positions. For example, if we own 1,000 shares of IBM, which currently trades around $145 per share, we could buy 10 IBM put options with a $145 strike price. If the option expires in March, we would be protected from $145 down, meaning that regardless of where IBM traded, even if it went to $0, we could still sell it at $145 per share, at any time up through the March expiration of the option contracts. There is, of course, a cost to buying the put options, much like buying an insurance policy. Options are a good tool that can be used, not just at the end of the year, but anytime the investor has a gain, and/or is concerned about the stock declining significantly in price. (Options can be tricky, so those investors inexperienced in options should consult an expert.)
Another consideration with stocks is to match capital gains with capital losses. If you are concerned about the stock market correction, or about an individual stock that you own, which has done well, falling in price, and if you have another stock that has done poorly, you can offset the gain on the good position with the loss on the bad position, assuming that the loss is at least as much as the gain. If the loss is less, you will still incur some capital gains on the profit, but it will be less than it would be without the offsetting loss.
Another reason to wait until the following tax year to realize a capital gain (on stock or anything else) would be if you are expecting your income in the following year to be substantially lower than in the current year, which would put you in a lower tax bracket. If this is the case, deferring the capital gain may save you significantly on your taxes, so the put option may make more sense.
Keep in mind also that, if you have owned a stock for less than one year, the capital gain will be considered ordinary income, and therefore will increase your overall income, possibly pushing you up into a higher bracket.
Another tip to consider at the end of the year is funding an IRA. Luckily, we actually can fund an IRA for 2010 all the way up until April 15th of 2011, but it is a good idea to at least plan for the investment, especially if we need time to save-up the contribution.
Another good tip is to defer income. If a bonus or additional income will push you into a higher tax bracket, if received before the end of the year, try to defer receiving it until 2011, especially if you think you will earn less next year. Some companies want to pay bonuses and additional compensation in the current tax year for their own benefit, but to the extent that you have a choice, it may make sense to push the income into 2011.
You can also write your checks for property taxes and for your mortgage payment by December 31st, to receive the tax benefits for the 2010 tax year. This can be particularly beneficial if your 2010 income is higher than you expect your 2011 income to be.
You can also charge business and personal expenses that are tax-deductible on a credit card prior to the end of the year, and then actually pay for them later (when the bill comes, or over time if you prefer), receiving the tax deduction for these expenses for the 2010 tax year.
One final tip has more to do with planning ahead for the 2011 tax year—this is the perfect time to review your tax withholding options, your 401(k) or 403(b) contribution levels, and your investment portfolio. We already spoke about some possible tax strategies for an individual stock or other investment that has performed well. You should also review your entire portfolio, so that you can not only identify any gains or losses that you might want to take or defer, but also compare your current asset allocation—the division of your assets among stocks, bonds, cash, real estate, commodities, art, etc.—to your long-term asset allocation target. You should further review each position and evaluate it as it relates to the other positions in your portfolio to make sure you are comfortable with the risk in the position, and believe that it belongs in the portfolio.
With tax withholdings and 401(k) and 403(b) contributions, you should review what occurred over the course of 2010 and make any adjustments that are necessary, so that your 2011 withholdings and contributions are in line with your long-term financial goals.
By spending a little time on some end-of-year tax planning, you can minimize your tax liability and prepare for the new tax year with a game plan in place, and the confidence of knowing that you actually have a plan and you are proactively pursuing it. Hopefully these tips will help get you started, but you have to make the effort, so don’t put it off any longer!