Some shareholders in mutual funds will be surprised by a capital gains distribution in the next few days, in a year when for the most part they have experienced record losses in their accounts. But when investors redeemed billions of dollars in shares from mutual funds this fall, some of these funds recorded long-term gains. Mutual funds are required by the Internal Revenue Service (IRS) to distribute substantially all of their income to their shareholders, who must then report the distributions as income. To offset those gains or gains on the sale of stocks, they may choose to sell shares of funds or stocks that have lost value.
Tax-deferred savings, such as 401(k) plans, IRAs, 529 plans and annuities, are not affected by capital gains tax. Distributions from tax-deferred accounts are taxed as ordinary income, subject to higher rates.
While the concept of harvesting a loss for any gain that must be reported remains generally accepted, financial advisers have slightly different takes on harvesting tax losses for mutual funds and stocks. Ray Mignone, a financial planner in Little Neck, New York, says that investors can benefit financially from selling that stock or mutual fund that has losses but which may appreciate, but immediately reinvesting in something similar, according to Newsday. This way they can harvest the loss and get the tax advantage, while staying in the market. Under current IRS rules, taxpayers are able to reduce their taxable income in 2008 by $3,000 ($1,500 for single persons) and hold on to the remaining loss indefinitely for use in future years in increments of $3,000.
Dana Anspack writing for moneyover55.about.com takes a more conservative view, saying that this strategy does not work as well for stocks as for mutual funds because of the wash sale rule. “Although you can sell your existing stock, and realize the loss, you cannot easily replace it with a similar stock that would be expected to perform the same.”
Taxpayers who are not going to report a gain may still want to harvest their losses, especially those in the 28 percent bracket, and deduct the $3,000 in losses allowed by IRS rules against their taxable income. Before selling shares in a fund or stock to realize a gain or a loss, investors should:
- Pay attention to timing.
Short term gains. Sales of investments held for less than a year are subject to a short term capital gains rate, which matches the taxpayer’s tax bracket for ordinary income. Short-term capital gains distributed by a mutual fund company cannot be fully offset by individuals using short-term capital losses from elsewhere in their portfolio. Short-term capital gains are taxed as ordinary income.
Long term gains. For taxpayers in the 15 percent bracket or lower for 2008, the capital gain on the sale of long term investments is 0. Realizing a loss to offset a gain that is not taxed is not a tax saving strategy.
- Avoid a wash sale. A taxpayer may want to realize a loss on an investment that he or she is hoping will improve in the coming years. But according to IRS rules, when you sell an investment at a loss, the wash sale rule prevents you from currently deducting the loss if you buy back the same investment within 30 calendar days before or after the sale. If you violate the wash sale rule, your losses would be deferred and could not currently be used as a deduction.
Do not use the same ticker symbol for a mutual fund, says Matthew Hougan writing for BLOG IU.com. The wash sale rule does not apply to mutual funds with different ticker symbols, even if the two funds own the same underlying securities.
- Consider current and future liability. Taxpayers might postpone realizing gains and losses, because they might not have a significant current liability or might be in a higher tax bracket next year.
Other capital gains taxpayers might need to report in 2008 could include sales of art, jewelry or other collectibles for a profit, which are taxed at 28 percent, according to the IRS, or the sale of a home. Most financial advisors, including those at Prudential Securities and Vanguard.com, say that realizing a loss should be done in the context of the taxpayer’s individual circumstances and recommend that they consult a professional tax advisor.