Admitting a mistake never is easy, especially when it comes to investing. But doing just that could be a smart move for investors eager to reduce the sting from painful bloopers.
With the Standard & Poor’s 500 stock index down nearly 4% so far this year and lots of uncertainty about the future, it may be time to consider a popular tax strategy known as "tax-loss harvesting." Start by examining your holdings for stocks, bonds, mutual funds and other investments that now are valued at less than you paid for them. Focus especially closely on securities you were thinking of selling anyway because their prospects appear poor.
It may be tempting to hang on to those losers and pray for an eventual market rebound. Instead, consider selling them to nail down, or "harvest," those losses. As painful as this may be, capital losses can help reduce your tax burden.
Tax-loss harvesting is especially popular around the end of each year as investors take a fresh look at their holdings and search for ways to trim their taxes. This year, it might be smart for many upper-income investors to take action sooner. The reason: President Obama has asked Congress to approve legislation raising the top rate on long-term capital gains to 20%, effective in 2011, for married couples filing jointly who make more than $250,000 and singles earning over $200,000. If that happens, there could be an unusually large amount of selling later this year by investors eager to beat the tax increase, which could push prices down further.
Capital losses can be valuable at several levels. First, investors typically can use their capital losses to offset capital gains on a dollar-for-dollar basis. There is no dollar limit on the amount that can be used. If your losses are bigger than your gains, or if you have no gains at all, you typically may deduct as much as $3,000 of that net loss from ordinary income, such as wages and interest. (The limit is $1,500 for someone who is married and filing separately.) Additional losses can be carried over into future years.
More details, such as how to report gains and losses on Schedule D of Form 1040, are in IRS Publications 17 and 550, available on the www.irs.gov IRS Web site. Those publications discuss other issues, such as the difference between "short-term" and "long-term" gains and losses. Short-term means an asset held one year or less. Long-term refers to an asset held more than one year.
Investors thinking about harvesting losses should watch out for a tricky tax trap known as the "wash-sale rule." A wash sale happens when someone sells stock or other securities at a loss and buys the same thing, or something "substantially identical," within 30 days. (Note: This means 30 days ((open bf ital)) before or after ((end bf ital)) the sale -- not just 30 days after the sale, as some people think.) Violate this rule, and the loss can’t be deducted. An investor who does violate the rule and can't take the loss is supposed to add the disallowed loss to the cost of the new securities, according to the IRS.
All this doesn’t mean investors should race out right away and dump all their losers purely to harvest tax losses. One of the oldest investing rules is never to make any significant decisions exclusively for tax reasons. Instead, those moves should be based on solid investment reasoning.
Even so, tax-loss harvesting can be a wise move for someone who was thinking of selling certain stocks and other securities anyway.
