Many investors won't be sorry to see 2011 come to a close. Heart-stopping market gyrations have left many distraught over their shrinking nest eggs.
But there's still time to make your battered portfolio pay off by making some smart tax moves. Here's what you need to do with your investments before the year ends, as well as a couple of tips to cut your tax bill in 2012.
Dump the dogs: If you have losing stocks that appear hopeless, there's no better time to sell and claim a tax deduction for the loss.
But don't sell a stock that you still believe in. Tax authorities will not let you claim the capital loss if you buy back the stock within 31 days. If the stock appreciates during that stretch, you could easily lose more on the investment opportunity than you saved in taxes.
Focus on your funds: Tax-loss harvesting can be more rewarding and less risky if you own mutual funds in taxable accounts. (Tax-favored retirement accounts such IRAs and 401(k)s aren't eligible.)
While tax rules forbid you from buying back the same or "substantially identical" securities within 31 days, there are many mutual funds that are similar. That could give you the opportunity to sell one fund at a loss while buying another with similar investment prospects at the same time.
What differentiates one fund from another for tax purposes is often a judgment call. But if the fund company and fees are different or if the new fund allows you to trade more freely, you can argue that the investment is different enough to avoid the "wash sale" rules that would otherwise prevent you from claiming a capital loss.
Moreover, if you had a broad-based index fund, you might sell that and buy several funds that focus on specialized segments of the market that you think are more likely to excel, said Frank Fantozzi, chief executive of Planned Financial Services in Cleveland. A swap like this isn't even a judgment call. It's a good way to harvest a loss while potentially putting your portfolio in a better position to be profitable, Fantozzi said.
Investment losses can be used to offset investment gains. If you have more losses than gains, up to $3,000 per year can be used to reduce ordinary income. Any remaining amount is rolled over for use in future years.
Donate winning stocks: Planning to give a big charitable gift this year to save on taxes? Instead of cash, give an appreciated security that you would otherwise sell.
Here's how it works. Say, for example, you bought 100 shares of a well-known tech stock for $85 per share, or $8,500 total, in 2009. (We'll let you guess what stock we're referring to.) But now those 100 shares are worth about $38,000.
If you sold the stock and gave those proceeds to charity, you'd have to pay a 15% capital gain on the profit, which would cost you $4,425 in federal tax, plus about $2,700 in California income taxes if you live in the Golden State. (California has no special capital gains rate, but the taxes you pay to the state are deductible on federal returns.)
You would, however, get a tax deduction for the $38,000 gift on both your state and federal taxes. Assuming you pay 35% of your income in federal and state tax, that gift would save you roughly $6,175 in taxes. (That's the $13,300 value of the charitable deduction, minus the taxes you're paying on the gain.)
But if you simply give those shares to a charity, you would get a deduction equal to the current market value, and you never have to pay tax on the gain. Net savings is $13,300 — about $7,125 more than you would have reaped if you had sold the shares and donated the proceeds.
Max out your retirement plans: If you have a 401(k) plan at work, you should be contributing the maximum amount. Every dollar contributed reduces your taxable income and both your federal and state income tax. Raising your contribution amount before year-end won't do much to help you this year, but you'll be set heading into 2012.
If you don't have a 401(k) or another qualified retirement plan, consider contributing to a tax-deductible IRA. In 2011, you can contribute a maximum of $5,000 — $10,000 if you're married filing jointly with a non-working spouse. If you're older than 50, you can make a catch-up contribution of an additional $1,000 per person for a total of $6,000 per person or $12,000 per couple. That saves you $2,100 per person in taxes, assuming a 35% combined tax rate.
An added benefit of an IRA: You can make contributions until next year's filing deadline of April 16. (The filing deadline is normally April 15, but it will be extended one day because April 15 is a Sunday next year.)
Now the bad news: Those who do have access to a qualified retirement plan can deduct IRA contributions only if their adjusted gross income is below certain levels — $56,000 if you're single, $90,000 if you're married filing jointly. The deductions are phased out for those earning more. They evaporate completely for singles earning $66,000 and for married couples earning $110,000 or more.
Open a Simplified Employee Pension Plan: If you have some self-employment income, you should also open a SEP-IRA. These plans allow you to set aside up to 25% of your business income in a deductible account each year to set limits. This account does not need to be funded in 2011. It just needs to be set up before the end of the year. You can contribute to it any time before the tax- filing deadline of April 16.