How to Make the Most of Your End-of-Year Investment Planning – Published in Noozhawk on Monday, November 25, 2013

Two-thousand-and-thirteen has been an exceptional year for stock performance, to say the least, with the Standard & Poor’s 500 Index returning 26 percent year-to-date. As we approach the end of the calendar year, investors will want to consider some end-of-year planning options to maximize returns, avoid potential losses and minimize tax implications.

Not everyone participated in this year’s impressive stock market returns. Still others only partially benefited. For those who were smart enough or lucky enough to have been fully invested, or at least significantly invested, in stocks for the entirety or majority of the year, some considerations should be given to end-of-year planning.

For those with significant unrealized gains, and who also have portfolios that include qualified accounts — IRAs, 401ks, etc. — stock market positions can be sold within these qualified accounts without incurring a tax liability. So, for those who have gains and who also are worried about a possible correction in stocks in the near term, this could be a good time to reduce exposure to stocks without increasing tax burdens.

A second option, again for those with significant stock market gains, but who do not have qualified accounts, and who additionally may have used dollar-cost-averaging — purchasing stock in the same company incrementally over time in fixed amounts each month — or for those who have made multiple purchases over time, would be to match the sale of positions with the highest-priced purchases to minimize tax burdens.

For example, let’s say an investor purchased 100 shares of Google four times during the year, as the stock has increased in price:

Jan. 2, 2013 $720
April 1, 2013 $800
July 1, 2013 $890
Nov. 1, 2013 $1,035

If the investor would like to reduce his or her exposure to Google to 200 shares from 400 shares, he or she can sell the 200 shares purchased on July 1 and Nov. 1, which have the highest cost-basis, thereby reducing the tax liability, as compared with selling the shares purchased at lower prices earlier in the year.

The investor must specify to the brokerage firm which shares (tax lots) he or she wants to sell at the same time so the firm can indicate which tax lot to match to the sale. The Internal Revenue Service assumes FIFO (first in, first out) so, in our example, if the investor does not specify that he or she wants to sell the November and July purchases, the IRS will assume the first ones purchased — the January and April purchases — are being sold. More often than not, FIFO results in the largest possible tax burden (which is what the IRS wants, but isn’t usually what the investor wants).

Another tax consideration is long-term versus short-term capital gains. Long-term capital gains are gains earned when positions are held for more than one year, while short-term gains are gains resulting ins positions held for less than a year. For most investors, long-term capital gains are taxed at 20 percent, while short-term gains are taxed at the investor’s ordinary income tax rate, which is usually much higher than 20 percent. (It is always a good idea to keep detailed records of all transactions.)

Investors need to consider how long they have held positions when choosing tax lots, since selling a higher priced position may still result in a higher tax burden if that position has been held for less than a year.

For individual stock positions, investors who do not want to sell positions — either because they still believe the position can go higher or because they do not want to incur the tax liability for the capital gains — can buy a put option to protect them from downside risk. The investor must evaluate the cost of buying the put in relation to the possible tax burden and the potential for further upside in the stock, to see if buying the put makes good financial sense. (Options are a bit complicated so investors should not buy or sell them unless they have a thorough understanding of how options work. When in doubt, consult an expert.)

Another big-picture consideration involves looking at the investor’s overall portfolio at all positions to identify any possible offsetting losses that can be taken. Since the stock market has experienced such strong gains, most investors will have unrealized gains in their portfolios. These same investors may also have unrealized losses, as well, either in stocks or in other assets. Assuming that an investor wants to realize some gains, he or she may want to also realize some losses to offset the tax burden. By matching gains with losses, investors can reduce exposure — and risk — while minimizing the overall tax burden.

Another possible strategy involves charitable giving. If an investors have gains that they wish to realize, and want to reduce their tax burden, they could either sell positions and also make donations to their favorite charities to generate tax deductions to offset those gains, or they can consider donating appreciated stock, which will generate a tax deduction that can be used to offset taxes for other realized capital gains.

Another strategy for offsetting taxes incurred through trimming stock positions would be to realize any unrealized losses investment properties. If the investor has an investment property that is sold for a loss, the loss can offset any capital gains incurred on stock positions.

Finally, if an investor expects that he or she will be in a higher income-tax bracket in future years, and has short-term capital gains that they would like to realize, it may make sense to go ahead and realize those gains in the current tax year, rather than waiting until next year when the tax bracket could be higher. Again, the investor will want to look at when the short-term capital gain will become a long-term gain, to determine if selling now is preferable (would result in a smaller overall tax liability) than waiting.

As with all tax-related decisions, each investor must analyze and understand their choices and should always consult their tax adviser before making any changes to portfolios. While this discussion is for information purposes only and should not be construed as tax advice, my hope is that it will motivate readers to consider their options and make more informed decisions regarding their investment portfolios.

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