NEW YORK — This year’s steep drop for stocks means that so-called tax-loss harvesting is more popular than ever.

The tactic of selling securities at a loss to reduce long-term capital gains tax is a common year-end option for burned investors. As portfolio managers weed out losing stocks, financial advisors are hearing from a rising number of clients who want to know how to use the tax strategy to buffer losses.

Both stocks and mutual funds are fair game, though the rules are a bit different for each. Mutual fund shareholders may stand to benefit this year if they hold funds hit by a lot of redemptions.

Don Weigandt, wealth advisor at JP Morgan Private Bank in Los Angeles said his firm is doing tax-loss selling as it rebalances client portfolios as part of its third-quarter investment performance reviews.

“We expect to be doing more of this through the balance of the year,” said Weigandt.

As with any tax strategy, loss harvesting isn’t something that should drive investment decisions. Rather, Weigandt and other advisors say it should be used to complement an overall approach.

It’s particularly important this year to know what tax result will arise from selling a stock, according to Melbert E. Schwarz, national tax partner in the Washington, D.C. office of Grant Thornton LLP.

Keep good records and know how much of a gain or loss each sale will produce.

In order to figure capital gains on a stock, the taxpayer must know its cost basis, essentially the amount originally paid for it. Someone who sells a bunch of shares he bought in a company over time may have bought a few of the shares at $100, some at $50, some at $150 and some at $20.

“Obviously, I’m going to have different results for all these,” said Schwarz.

On stock sales, the taxpayer reports capital losses on Schedule D of Form 1040. Brokerage statements or confirmations from a broker who executed the trades is the usual documentation. Ideally, the record should show the taxpayer designated which shares he wanted to sell.

Currently, the only thing the broker reports to the Internal Revenue Service is the gross amount of proceeds from the sale. Starting in 2011, brokers will be required to report the cost basis of certain securities as well.

Taxpayers can claim a net capital loss of up to $3,000 each year. The loss offsets ordinary income that would otherwise be taxed at a rate as high as 35%. Losses over $3,000 can be carried over to subsequent years indefinitely.

Kaye Thomas, said many people have the misconception that they must limit losses to $3,000 each year.

“I tell people “No, it’s better to have a capital loss over $3,000, so that you have a capital loss carryover you can use in future years,’” says Thomas. “It expires when you do.”

On the other hand, a taxpayer with losses under $3,000 for the year may be tempted to sell additional appreciated stocks in order to “use” more capital losses in the current year. This isn’t a great idea if he doesn’t really want to sell the stock, according to Schwarz.

The wash sale rule is a potential tripwire in tax-loss harvesting. It penalizes anyone who sells a stock and buys it back within 30 days. A common strategy to avoid running afoul of the rule is to replace the stock that’s been sold with another that looks likely to perform the same way. Caveat: Using a too-similar stock breaks the rule.

Mutual fund investors who are thinking about harvesting their losses now may be better off waiting until they know more about how funds will handle their own capital gains, said Rich Rosso, a vice president and financial consultant in a Houston branch of Charles Schwab Corp. (SCHW).

Many fund companies will soon say whether they plan to pass capital gains from sales of stocks in the funds through to shareholders. Faced with a capital gains pass-through, an investor may want to switch to a more tax-efficient mutual fund or exchange-traded fund, said Rosso.

“It comes as a big surprise to some people when a fund they hold is down but they owe capital gains tax on it,” said Rosso.

End-of-year capital gain distribution by mutual funds can present a particular problem in down years like this. A mutual fund with a lot of redemptions may need to sell long-term holdings to raise cash. This results in capital gains that must be passed through to a smaller pool of shareholders.

Loss harvesting may be appropriate in such situations, according to Schwarz.

Mutual funds that tout themselves as tax-efficient, he added, can be particularly susceptible to this problem, because they may have avoided selling appreciated shares until forced to by net redemptions.

Extreme volatility in the stock market means there’s potential to be burned by tax loss harvesting now. The wash sale rule may prevent one who sells a stock from capturing an upswing days later.

On the other, it’s something that should get a look from anyone with big losses in a taxable account.

By Arden Dale
A DOW JONES NEWSWIRES COLUMN

Sen. John McCain wants to help Americans use their nest eggs to cope with the current economic turbulence.

McCain, R-Ariz., the Republican presidential nominee, today released a pension and family security plan.

One provision in the McCain proposal calls for the government to let taxpayers ages 60 and older pay a tax rate of just 10% on 2008 and 2009 withdrawals from individual retirement accounts and 401(k) plans.

The low withdrawal rate would apply to the first $50,000 withdrawn, according to a summary of the proposal prepared by the McCain campaign staff.

McCain’s Democratic opponent, Sen. Barack Obama, D-Ill., proposed Monday that all taxpayers be permitted to take up to $10,000 in retirement account hardship withdrawals in 2008 and 2009.

Under the Obama plan, the usual tax penalties would be eliminated, but the taxpayers taking the withdrawals would have to pay the usual income taxes on the amounts withdrawn.

Like Obama, McCain is proposing that the government suspend a requirement that normally would require retired taxpayers to start withdrawing assets from retirement accounts at age 70.5.

“Forcing seniors to sell at this time guarantees less to live on during retirement and could affect over 4 million seniors,” the McCain campaign says in the McCain economic proposal summary. “John McCain believes this [rule] should be immediately waived.”

NU Online News Service, Oct. 14, 2008

WASHINGTON — The prospect of higher taxes on long-term capital gains and dividends may spur a selloff of stocks and other assets by the end of this year, according to wealth-management advisors.

Investors and business owners are on high alert because of a proposal by Sen. Barack Obama, D-Ill., the presumed Democratic presidential nominee, to hike capital gains and dividend tax rates for many investors by between five and 13 percentage points.

Some advisors are telling clients to consider taking gains soon, because tax rates could change next year, particularly if Democrats win the White House and hold on to their congressional majorities.

“For the foreseeable future, you’re not going to get a better chance to move out of appreciated positions, from a tax perspective,” said Hank Alden, an advisor at Everest International Group.

Investment advisors caution that taxes alone should not be the overriding factor in investment decisions and decisions to buy or sell should be made as part of an overall strategy related to one’s portfolio.

But for many investors who have stocks or other holdings that they would otherwise sell in the next several years, the window for doing so at preferential tax rates may be closing.

Obama wants to bump the long-term capital gains and dividend rates up from their current level of 15% to at least 20%, and possibly as high as 28%.

The higher rates would apply only to individuals with income in excess of $200,000 or more, or couples earning more than $250,000.

Jason Furman, economic director for the Obama campaign, said that even for those making more than that amount, “we believe a rate much closer to 20% would be feasible.” That is based on campaign projections that assume that other Obama proposals would also be enacted.

Obama’s opponent, GOP nominee-designate Sen. John McCain, R-Ariz., favors keeping the capital gains and dividend rates at 15% for all investors, regardless of income level.

Screening for “Insiders” Business owners in particular may accelerate plans to sell their firms because of a looming capital gains increase, wealth advisors said.

“A number of family businesses have asked us the question, if we sold later than 2008, how much would my business have to appreciate just to break even,” or to realize as much profit as they would if they sold in 2008, said Jeff Paravano, a partner at the law firm of Baker Hostetler.

“When they see the spreadsheet, and the additional tax, a number of them have decided to sell this year,” Paravano said.

Some investors are even trying to turn a looming tax increase to their advantage by betting that business owners will sell before the tax hike. Investment advisor Robert Willens said some investors are “screening” for companies where founders or their descendants own a large share of the company stock.

Since those “insiders” are likely to have a low basis, they will be more motivated to avoid the tax hit by selling the business before the higher rate kicks in, he said.

“If investors believe a company will be sold at a premium, they may buy in the hope of reaping gains,” said Willens.

Dividend Rate Hike

Companies that pay dividends and their shareholders also are feeling pressure to act ahead of any tax hike.

Some companies may accelerate their fourth-quarter dividend payment from December 2008 from January 2009, according to Paravano.

In anticipation of a higher tax rate on dividends, investors who hold income-producing stock may want to shift to stock that doesn’t pay dividends and roll that into a tax-preferred savings vehicle such as an individual retirement account. That way the entire investment could appreciate without being taxed until the IRA is cashed out.

But they will be limited by annual contribution limits to IRAs, set at $5,000 for 2008, with an additional $1,000 for individuals over 50.

Uncertainty about how quickly Congress might move to raise taxes, and when higher rates will actually take effect, adds to the urgency. While recent GOP-led Congresses have typically made tax changes prospective from the date a bill is signed into law, that has not always been the practice, according to wealth advisors and economists.

Under current law, the 15% rate on capital gains and dividends is in effect until the end of 2010. But many observers expect Congress to act next year to fix the estate tax. Facing budgetary pressures, lawmakers may move at the same time to hike capital gains, dividend and other tax rates that were cut during President George W. Bush’s first term.

Economic Impacts

Rep. Richard Neal, D-Mass., said lawmakers will weigh carefully the effect of tax increases on an economy already burdened by high energy prices and credit woes. “We don’t want to do anything that would slow a recovery. But the deficit is a very stubborn fact,” Neal said in an interview.

Economists disagree over the broad economic impacts of an increase in the capital gains and dividend rates. Stephen Entin, president and executive director of the Institute for Research on the Economics of Taxation, has argued that a hike in the capital gains rate to 25% could damp the gross domestic product by as much as 6% over the long term.

But Furman of the Obama campaign said there is evidence that measured increases in tax rates that help reduce the deficit, as Obama is proposing, will not have a sustained negative effect on the economy.

Furman also said other Obama proposals will encourage savings and investment, such as an enhanced saver’s credit for lower-income earners.

“What investors should look at is what’s going to happen to overall economic policy. This is a change in economic strategy to emphasize fiscal responsibility in a way that we haven’t seen,” said Furman.

By Martin Vaughan
Of DOW JONES NEWSWIRES