Smart Year-End Tax Moves for Investors

There are plenty of reasons for taxpayers to scream. Here it is, year-end tax-planning time, when investors must decide whether to take gains or harvest losses and make important retirement-account choices. Yet crucial questions remain—not only about next year's tax law but also about this year's.
If Congress doesn't pass an extension of the Bush-era tax rates for upper-income earners, the top rate on long-term capital gains will rise by one-third next year—an increase that is double the rise in rates on ordinary income. The rate on dividends, meanwhile, could nearly triple. And many taxpayers are still waiting for answers on the 2010 alternative minimum tax, the estate tax and the gift tax.
Adding to taxpayers' anxiety, two serious overhaul proposals were just announced in Washington—one from President Obama's deficit commission and the other from the independent Bipartisan Policy Center. While it is unlikely they would be enacted in current form, they take aim at many prized benefits, from the mortgage-interest deduction to low capital-gains rates. It's natural to fear that moves made now could prove useless later, or even backfire.
Given all the uncertainty, is your annual year-end tax-planning session worth the effort this year? Yes—in fact it is crucial, because it could be your last chance to take advantage of today's low rates.
Congress will address taxes in December, and may (or may not) clear up 2010 and 2011 issues before year-end. Advisers like Mark Nash of PricewaterhouseCoopers LLP in Dallas are urging clients to get ready to pounce once the law becomes clear. "We are making plans [for clients] now that can be executed quickly before the end of the year, or looking at moves—like Roth IRA conversions or installment-sale elections—that can be revised next year," he says.
Even if Congress merely extends current law, understanding "wash sale" rules, loss-harvesting and Roth IRA conversions now can pay off later.
That is because the window is closing on current investment tax rates, now at historic lows. Already, many investors face a substantial tax increase in 2013 passed by Congress as part of the health-care overhaul. Every financial and political analyst interviewed for this story expects taxes on investments to rise more than taxes on wages in coming years.
The good news? Investors have enviable flexibility when it comes to timing income and deducting losses—far more than wage earners. There's so much to say about investment tax planning that we're saving other year-end tips for next week.

Capital Gains and Losses

If Congress extends the Bush 2001-03 tax rates for couples earning more than $250,000 ($200,000 for singles), then the top rate on long-term capital gains (those held longer than a year) will remain 15% for a year or two. If lawmakers don't extend the current law, then on Jan. 1 the top rate on gains will rise to 20%.

Whatever the outcome, a new 3.8% tax on investment income takes effect in 2013 as a result of the health-care overhaul. It applies to income from rents, royalties, dividends, capital gains and interest (except municipal-bond interest) for nearly everyone with adjusted gross incomes over $250,000 ($200,000 for singles). (For details, see "How the New Wealth Taxes Will Hit You," June 12.)

What you can do. People with liquid investments should prepare to act quickly this year if the Bush cuts aren't extended, or later if they are. That means understanding some important details of current law.
• Loss harvesting. If you sell an investment at a loss, you can use up to $3,000 per year of the loss to offset ordinary income like wages and "carry forward" the rest to shelter future investment gains. (Note: These rules apply only to investments held in taxable accounts, not tax-sheltered retirement plans such as individual retirement accounts and 401(k) plans.) Short-term losses are those from investments held a year or less, and long-term losses are from those held longer.
The rules on overall gains and losses are intricate but give investors room to optimize results. "Smart investors pay close attention to the timing of gains and losses in order to minimize taxes," says independent tax analyst Robert Willens.
If tax rates rise next year, it may make sense to hold off taking losses until January, when their value will be greater. On the other hand, many investors still have losses they took during the terrible downturn of 2008. If they can take short-term gains this year, Mr. Willens suggests doing so to use some of those losses. This can often work with proper planning.
Why use the losses this year instead of next if tax rates are going up? Although the losses would in theory be more valuable next year, Mr. Willens and others usually advise using them as soon as possible, because the market could change and waiting too long could erode their value.
Here's an example. Susan has $40,000 of losses left from 2008. This year, she has $50,000 of potential gains: $30,000 is long-term and $20,000 is short-term. She wants to use her loss and is worried about the prospects of the stock with the short-term gain. So she sells all the stock with the $20,000 short-term gain and enough of the long-term holding to realize $17,000 of gain.
The result: $37,000 of short- and long-term gains are sheltered this year, with $3,000 of losses left to offset her wage income. Why save $3,000 of the loss to offset wages? Because ordinary income is taxed at much higher rates than long-term gains, it's a more lucrative offset.
• Understand the wash-sale rules. If you sell an investment at a loss, you don't get the loss if you also buy the same holding 30 days before or after the sale. What many don't know is that these rules apply only to losses, not to gains. In the above example, Susan was free to re-acquire the stock she sold right away at a higher cost basis, which will reduce her taxable gain in the future. As long as transaction costs are low, it often makes sense to "scrub" your gains if you have losses.
• Mix and match. When reckoning gains and losses, remember that those on mutual funds and exchange-traded funds can offset gains from stocks, and vice versa.
Tax strategist Robert Gordon of Twenty-First Securities Corp. in New York notes that many taxable bonds have appreciated as interest rates have fallen. If an investor holds individual bonds with long-term gains, he suggests selling the bonds, in effect converting interest payments taxable at ordinary rates to long-term capital gains with a top rate of 15%. If the investor buys the bond back right away, he should elect to deduct the premium from the interest payments over the remaining life of the bond.
What if you are selling an entire business instead of a liquid investment? Many are pushing to finish deals before the end of the year, says Mr. Nash. Failing that, he says, some people with deals under way are selling the business to a trust before the end of the year to take advantage of the 15% rate, and letting the trust sell it next year. This is a complex move but could be useful this year for people selling substantial assets who have a buyer.

Dividends

If lawmakers extend the Bush 2001-03 tax cuts for upper-end taxpayers, the top rate on dividends will remain 15%. If they don't, the top rate may stay linked with the one for capital gains and rise to 20% (as requested by the Obama budget), or dividends will once again be treated as ordinary income, with a top rate of 39.6%.

What you can do. Individual investors can do little. Those who control companies can have them pay dividends before the end of the year. Several public companies, including Wynn Resorts Ltd., Limited Brands Inc. and Progressive Corp., have paid special or extraordinary dividends recently, ahead of possible changes next year.

Stock Options and Restricted Shares

So-called nonqualified stock options and restricted stock are now the most common forms of executive stock compensation. Employees who receive either type usually owe ordinary income taxes and payroll taxes (FICA) on the stock's value at current market prices when they exercise the options or the restricted stock vests. If they continue to hold shares more than a year after that, appreciation is taxed at long-term capital-gains rates, without payroll taxes.
If the Bush tax cuts aren't extended for all, the top rate on ordinary income will rise to 39.6% from 35% and on capital gains to 20% from 15%. In addition, there is the new 3.8% tax on investment income (described above) coming in 2013. The 2013 tax also adds a 0.9% payroll tax to the wages of couples making over $250,000 ($200,000 for singles). It would apply to income recognized when options are exercised or restricted stock vests.
What you can do. Plan not only for this year but also the next two, with the 2013 taxes in view. There is a lot to consider: ordinary tax rates, capital gain rates and holding periods, plus the stock's current price and its future prospects.
Eddie Adkins, a benefits specialist with Grant Thornton LLP, says he sees savvy executives planning now to avoid the 2013 increases. Because it may be hard to come up with the cash required to acquire shares or pay taxes, many are doing "cashless" transactions in which some shares are sold in order to cover the costs of keeping others, he says.
One caveat: The wash-sale rules (described above) come into play here. A grant of options or restricted stock, or an option exercise, count as buying stock, so be careful not to harvest losses from the same stock within 30 days before or after.

Roth IRA Conversions

Roth IRAs are in many ways the gold standard of retirement accounts. Assets in them can grow and be paid out income-tax-free, and there are no mandatory distributions for the owner, as there are with regular IRAs. Tax-free Roth payouts don't count in calculations for alternative minimum tax, Social Security tax, Medicare premiums or the 3.8% investment income tax coming in 2013, at least for now.
This is the first year all taxpayers may convert other IRAs to Roth accounts regardless of their income. Many have jumped to do it, even though that means paying full income taxes on the transfer. Roth sponsors have experienced a surge, with Fidelity Investments and Vanguard Group reporting four to five times the number of conversions as of this time last year.

A key Roth boon is that people who convert can reverse the transaction as late as Oct. 15 of the following year. This has led some to put different asset classes into separate Roth accounts with plans to undo the ones that have lost value or grown less. (See Tax Report, Aug. 14.) For 2010 only, investors may also split the conversion income and report half in 2011 and half in 2012, paying taxes at then-current rates. If the Bush cuts are extended, taking advantage of the deferral could make sense.

What you can do. Remember that Roth conversions work best when the following are true: Your tax rate will be the same or higher in the future; asset values have been beaten down; you have outside money to pay the tax; and you can transfer assets without moving into a higher tax bracket. In some cases, a conversion that raises income may help you avoid the alternative minimum tax.
Even a small conversion will start an important five-year clock running. Once the five years is up, Roth payouts of both principal and earnings are tax-free for those over 59½; if not, only payouts of principal are tax-free until five years is up. A December conversion starts this clock running as of the previous January.
But January is often a good time to convert to a Roth IRA, because this leaves the longest possible time to undo the conversion: almost 22 months. Those who convert in January 2011 will have almost until the 2012 elections to decide whether to undo the transfer.
Many taxpayers fear that if they pay to convert, Congress will change the rules in the future. The issues are many, but at least one expert familiar with tax theory and history, Columbia University Law School Professor Michael Graetz, plans a partial Roth conversion early next year.
"Waiting until next year gives until October 2012 to undo the conversion, and we should know more about where Congress is heading," says Prof. Graetz.
For one group of taxpayers who want to save for retirement—those who don't have current IRAs—a Roth conversion is close to a no-brainer. These investors can open a "nondeductible" IRA, put in up to $5,000—$6,000 if they're at least 50—and immediately convert to a Roth IRA with little or no tax.
This strategy doesn't work well for those who already have large IRAs, unless they're converting all their accounts. That's because partial conversions have to be prorated among pretax and after-tax IRAs. PricewaterhouseCoopers's Mr. Nash notes that this move can work for executives who have earned too much to have a deductible IRA, and sometimes their spouses as well.