Edward A. Zurndorfer, Certified Financial Planner

During the past few years, year-end tax planning for those individual investors owning non-retirement portfolios consisting of stocks, bonds and mutual funds has been fairly straight forward; namely, sell those capital assets which have decreased in value since their purchase date thereby generating capital losses.

Next, apply these capital losses to capital gains generated during the year and apply any excess capital losses up to $3,000 to other income including salary, interest and rental income. In so doing, individuals are able to decrease their federal and in most states their state income tax liabilities. All of the individual investor's capital losses in excess of $3,000 can be carried over to future years and used to offset future recognized capital gains until the earlier of the individual's death or when the capital losses are used up.

But for this year, year-end tax planning may prove to be something other than straightforward. The extreme downturn in the stock market during 2008, the rebound in the stock market during most of 2009, and the uncertain direction of future tax rates are proving to be a challenge for individual investors who are performing year end investment analyses and perhaps rebalancing their non-retirement investment portfolios. 

Since the end of the first quarter of 2009 (March 31), the stock market has rallied. Some stock indices -- both U.S and foreign -- are up as much as 40 to 50 percent. Many individuals have experienced capital gains either by selling their stocks, bonds or mutual funds or through capital gains distributions in their mutual funds. In the case of mutual funds, a significant amount of the capital gains distributions may be offset by any carryover losses from 2008.  Many investors who sold stocks, bonds or mutual funds at a loss during 2008 and early 2009 may be able to absorb any carryover losses from 2008 with capital gains generated during 2009 and could have carryover capital losses into 2010. 

While there is no certainty with respect to the direction of income tax rates, most tax professionals predict that tax rates -- including the rates on long-term capital gains -- are likely to increase in the coming years. Upper income taxpayers are especially vulnerable to tax increases.  The Obama Administration has recommended that the current top 33 and 35 percent tax brackets be increased to 36 and 39 percent respectively. Long term capital gains (those gains resulting from the sale of capital assets owned for more than one year) tax rates are also expected to increase from the current 15 to 20 percent. In addition, there is no guarantee that the long term capital gains tax rate will remain at 20 percent. As recently as 1998, long-term capital gains were taxed at 28 percent. 

During 2009, individual taxpayers in the 10 and 15 percent income tax brackets can take advantage of a 0 percent tax rate on long term capital gains. For single taxpayers whose taxable income during 2009 is no more than $33,950 and for married taxpayers whose taxable income during 2009 is no more than $67,900, they will pay no tax on long term capital gains incurred during 2009. The 0 percent rate is scheduled to apply through Dec. 31, 2010. The Obama Administration wants to make the 0 percent rate permanent for low income bracket taxpayers.   

Given the present and anticipated future direction of tax rates -- how should individual investors proceed with year-end investment portfolio management and rebalancing? Capital gain tax rates are expected to increase in the future. Low income taxpayers should certainly take advantage of the 0 percent tax on long term capital gains. 

For higher income taxpayers, it makes sense to maintain any losses incurred during 2007 through 2009 to offset future capital gains. By accumulating capital losses, future realized capital gains will be offset by these capital losses and therefore no capital gains taxes will be owed, no matter how much long term capital gains tax rates increase. 

But individual investors need to proceed with caution when taking losses on their investment portfolios. While the IRS permits loss carryovers from year to year, some states including New Jersey, Pennsylvania and Tennessee do not permit capital loss carryovers from year to year. 

The following is an example to illustrate on how to take advantage of capital losses. 

Julie invested $10,000 in the XYZ mutual fund on Jan. 2, 2001. On Oct 1, 2009, Julie sold the fund for $7,500 for a net capital loss of $2,500. If Julie has incurred during 2009 long term capital gains totaling $2,500, the $2,500 capital loss will offset the $2,500 capital gains, resulting in tax savings to Julie of 15 percent of $2,500 or $375. If Julie has no capital gains then the $2,500 reduces Julie's 2009 income by $2,500. If Julie is in a 28 percent tax bracket, then there will be a tax savings to Julie of 28 percent of $2,500, or $700.

Finally, investors need to be aware of the "wash sale" rules. An investor who sells a security -- this includes a stock, bond or a mutual fund -- at a capital loss may not repurchase the identical capital asset within 31 days before or after the day the security sold. If the investor does, the IRS will consider the sale a "wash sale" and disallow the loss.

One suggestion to avoid a "wash sale" is for an investor to wait at least 31 days before or after buying back a security that was sold at a loss. Another way is to buy another capital asset that is similar but not identical to the security that was sold. For example, instead of buying the ABC large company stock growth fund, the investor should purchase the XYZ large company stock growth fund.

Now may be an ideal time for individual investors to reevaluate their portfolios -- assuming there are capital losses carried over from 2008 and that the "wash sale" rule will not be violated during 2009. For example, an investor may want to consider reducing their equity (stock) and increasing their debt (bond) exposure. But saving on one's income taxes should not be the sole factor in determining an investor's portfolio allocations.

Tax and Legal Advice Disclaimer: Please note that Multi-Financial Securities Corporation nor any of its agents or representatives give legal or tax advice. For complete details, readers should consult with their tax advisor or attorney.

About the Author

Edward A. Zurndorfer is a Certified Financial Planner and Enrolled Agent in Silver Spring, Maryland. He is also a registered representative with Multi-Financial Securities Corporation (Branch A9X), member FINRA/SIPC, also located in Silver Spring, Maryland