Tax Planning

As the end of the year grows closer, thoughts turn to holidays, shopping, and . . . tax planning. Deductions are purchased. Income is deferred, or transformed into capital gains. Shelter is sought.

But how much tax-driven maneuvering is actually good for you? Sure, it gives you near instant gratification to look at your return and see that you’ve deducted away some of the tax liability. Have you also lost something else, though? Here are some things to keep in mind.

Investing comes first; taxes are secondary.

One typical 4th quarter tax maneuver is “harvesting” losses on stocks and other investments in order to offset gains on other investments. You sell some of your losers so you can reduce or avoid paying taxes on your winners. To make things even better, if you have losses remaining after offsetting capital gains (or if you have no capital gains), you can even use as much as $3,000 of losses to offset ordinary income (married, filing separately get $1,500 each). Excess undeducted losses can be carried over and deducted in future returns. Sounds like a good deal, no?

What if the stock you sold was actually a good investment that you should have held? There isn’t a stock that doesn’t go down in value some of the time, even the good stocks. Selling to generate a deduction may cost you a long term investment opportunity. Of course, you tell yourself, you would only sell the dogs. And that strategy works if you know which of your stocks are dogs. Sometimes, when a company has made an unequivocal turn toward bankruptcy court, you can fairly count it as a dog. But many of this year’s poor performers may be next year’s shining stars.

Don’t blindly sell a stock just because you want a deductible loss. Conversely, don’t hold a doggy stock simply because you have no gains against which to deduct it. Do what makes sense from an investment standpoint. Building wealth comes first and foremost from saving and intelligent investing. Remember that any deductible loss is a real loss that actually cost you money; it’s not something that occurred on a piece of paper. Wealth ultimately is not created from generating real losses.

There’s a strategy to avoid the lost opportunity problem: sell a loser before the end of the year and buy it back. That way, you’ll incur a loss and yet will own the stock for future gains. This strategy works, but only if you’re mindful of the rule against wash sales. If you buy the losing stock 30 days or less before or after you sell it, you may well violate the wash sale rule and be precluded from deducting the loss. The 30 day requirement is meant to put you “at risk” of market changes in the value of the stock, so that you can’t generate mere paper losses.

Tax Shelters

Another tax consideration is whether you should structure your investments to take advantage of tax shelters. The most readily available tax shelters for most Americans are retirement accounts like 401(k)s and IRAs. These general purpose retirement accounts have little or no investment bias. In other words, they don’t steer you toward any particular type of investment and can be used with a wide variety of investments. Thus, you can have a well-diversified portfolio within the retirement account. That makes these types of accounts highly desirable as tax shelters.

Most other tax shelters have a lot of investment bias. This is most easily seen in the thoroughbred stable/ostrich farm type of tax shelter, where your money must go into a particular type of investment in order to get deductible losses. Common tax shelters with investment bias are insurance products like whole life policies and annuities, where you shelter earnings on the money you invest (until it is distributed to you) only if you buy insurance products. Another very common tax shelter with investment bias is the municipal bond. If you want the benefit of this shelter, you have to allocate some of your hard earned savings to municipal debt.

Buying a tax shelter with investment bias is a good idea only if the investment bias makes sense within the context of your overall personal finances. Don’t invest in an ostrich farm unless it fits into an overall strategy of diversification. Remember that the first goal of investing is to generate gains, and an ostrich farm may not serve this goal as well as it provides deductible losses.

Don’t put 90% of your savings into muni bonds simply because you’re ticked off at the IRS, but haven’t quite reached the stage of buying a cabin on a ridge somewhere. The returns are low, even after you take account of the tax benefits. Defaults occur. And you can even be taxed for some municipal bond income under the alternative minimum tax, if the bonds are “private activity” municipal bonds. (Private activity bonds, sometimes called revenue bonds, are paid only from the revenues of a private enterprise that borrows the proceeds of the revenue bond offering from the issuing municipality).

Don’t buy an insurance product simply because you’ve maxed out your 401(k) and IRA. The insurance product may provide a tax shelter, but one that often comes with steep costs like commissions and fees (which you may have a hard time quantifying given the opaque nature of a lot of insurance contracts). Given the commissions and other expenses of many insurance products, opening a taxable account with a mutual fund company and investing in a low cost index fund may work out better for you in the end.

Most tax shelters resulted from lobbying by special interest groups and their tassled loafer-wearing lobbyists. They weren’t created with your personal finance needs as the uppermost priority. Don’t see these tax shelters as your uppermost priority.

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