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Portfolio investment strategies
Annual reviews
Review your asset allocation goals. How much of your assets did you plan to hold in equities? In fixed income? In cash? Compare your year-end position with your goals to see how they match up.
* If your portfolio is out of alignment, consider selling some assets to get your allocation back in line. Keep tax results in mind in taking gains or losses (discussed below).
Strategy: Rebalance your portfolio by directing new investments into the portion of your portfolio below its asset allocation target. For example, if you wanted to have 60% of your assets in equities and 40% in fixed income but your year-end holdings are $80,000 in equities and $40,000 in fixed income, your actual asset allocation is 67% in equities and 33% in fixed income. To rebalance, you can add $10,000 to your fixed income, putting your portfolio back to roughly a 60/40 allocation.
Even if your portfolio is within your targeted asset allocation, you may want to alter that allocation in light of changes in your personal financial picture or in the market. For example, you may have taken an aggressive 80% equity/20% fixed income approach in the past few years. But with changes in the stock market, you might now wish to modify your asset allocation to 60/40 or some other mix.
Portfolio tax strategies
You may have already taken gains and losses on securities transactions during the year. You may also be sitting on other potential gains and losses, paper gains and losses that you can actualize before year-end. By reviewing both paper and actualized transactions, you can act to reduce taxes and reposition your portfolio in light of changing investment philosophies and market conditions.
To optimize your tax position for the year, understand key rules on capital gains and losses. Here's a review of some key points you should keep in mind when reviewing year-end securities transactions:
* Long-term capital gains-gains on securities held more than one year-receive favorable tax treatment. The top tax rate generally is 15% (5% for those in the 10% or 15% tax bracket).
* Short-term capital gains-gains on assets held one year or less-are taxed at the same rate as your ordinary income up to 35%.
* Capital losses can be used to offset capital gains, plus up to $3,000 of ordinary income. Losses in excess of these limits can be carried forward and used-up to these limits-in future years.
* Losses cannot be taken if substantially identical securities are purchased within 30 days before or after the date of sale.
Strategies for optimizing gains and losses
Is your net gain a short-term capital gain or a long-term capital gain? Is your net loss a short-term capital loss or a long-term capital loss?
* If short-term gains exceed long-term gains, take losses (short-term or long-term) to offset your gain (to prevent such gains from being taxed at ordinary income rates). Short-term losses first offset short-term capital gains and then can be used to offset long-term capital gains. Similarly, long-term losses first offset long-term capital gains and then can be used to offset short-term capital gains.
* If long-term gains exceed short-term gains, you have net long-term gains taxed at up to 15%. You can opt to report your gains at this favorable tax rate or offset gains by taking capital losses.
* If you have net short-term or long-term losses, offset them by any type of capital gains (but preferably short-term gains otherwise taxed at ordinary income rates), leaving $3,000 of losses to be used to offset ordinary income. If your capital losses exceed your capital gains plus $3,000 of ordinary income, the excess can be carried forward and treated as a capital loss-short-term or long-term-next year.
Strategy: Put investment opportunities before tax considerations. Don't let tax results drive your investment decisions. Keep the settlement date in mind when you take gains and losses. For gain purposes, you must sell at least three days before the final trading day of the year. For loss purposes, you can sell up to the last day of the year.
Update basis records
As part of your year-end portfolio planning, update your records on the basis of stocks and mutual fund shares to reflect dividends and other distributions invested during the year. Your failure to make a basis adjustment can cause you to pay tax twice on the same money-once when you receive the distribution and a second time when you sell the stock or mutual fund shares and report more gain than necessary.
Reposition investments for tax impact
Use the proceeds from year-end securities sales to reposition your holdings not only for better returns but also for greater control over taxes in future years. Consider:
* Buying municipal bonds for tax-free interest.
* Buying non-dividend-paying stocks that aim for appreciation.
In this way, you report profits only when you sell your shares.
Income (and deduction) strategies for personal returns
You have some control over the income and expenses you have to report for the year. While many items occur automatically, others can be either kept in the current year or postponed to next year, whichever will prove more advantageous to you tax-wise.
