Year-End Tax Planning Moves for 2003

A few strategic moves today could save you a bundle come April 15.

IT'S NOT TOO LATE! Between now and Dec. 31, you can still take steps to cut your 2003 income-tax bill. Even better, the Jobs and Growth Tax Relief Reconciliation Act of 2003 has created some new opportunities that are simply too good to ignore. So read on -- and save.

Harvest Tax Losses in the Year That Works Best
Now's the time of year to think about dumping loser stock and mutual-fund investments (thankfully, you probably have far fewer than last year). You can use the resulting capital losses to shelter capital gains earned earlier this year, as well as any additional gains racked up between now and year-end. Once you've offset all your capital gains, you can deduct any remaining capital losses against up to $3,000 of highly taxed ordinary income from salary, interest, retirement-plan distributions, alimony and so forth ($1,500 if you use married-filing-separate status). After all that, if you still have some excess capital losses, they carry over to next year and become subject to the same rules all over again. (For more on the basics of capital gains, click here.)

But you probably know all this. This year, however, there's a one-time twist to consider.

If You Have Long-Term Losses to Harvest
Thanks to the 2003 Act, your long-term capital gains and losses for this year must be segregated into those from sales before May 6, 2003, and those from sales after May 5. Therefore, if you follow the time-honored strategy of harvesting some long-term capital losses before year-end, they will go first to offset any long-term gains from sales after May 5. Because those gains would be taxed at no more than 15%, your tax savings from harvesting long-term losses will be no more than 15%. That's better than nothing, but waiting could be the tax-smart move here.

Specifically, if you expect to have only short-term gains in 2004 (or no gains at all), you might be better off postponing at least part of your long-term loss harvesting until next year. That way, you could use the postponed losses to offset next year's short-term gains plus up to $3,000 (or $1,500) of next year's ordinary income. Since these amounts would be taxed at your regular rate of up to 35%, the wait-until-next-year approach could result in tax savings as high as 35%. (All you Cubs and Red Sox fans will easily understand any wait-until-next-year concept.)

On the other hand, if harvesting long-term losses before year-end would allow you to offset pre-May 6 long-term gains, your tax savings will generally be 20%. Better! And if harvesting losses before year-end would allow you to offset short-term gains and up to $3,000 (or $1,500) of ordinary income, the tax savings will be at your regular rate of up to 35%. Much better! In either of these latter scenarios, harvesting your losses this year rather than next year could be the tax-smart way to go.

If You Have Short-Term Losses to Harvest
If you harvest short-term losses before year-end, they'll go first to offset short-term gains earned anytime this year. These gains would be taxed at your regular rate of up to 35%. So your tax savings can be as high as 35%.

If you don't have any short-term gains, short-term losses harvested before year-end will go first to offset post-May 5 long-term gains that would be taxed at no more than 15%. So your tax savings would be at that low rate, which is OK but not great. Once your post-May 5 long-term gains are wiped out, any remaining short-term losses will go to offset pre-May 6 long-term gains that would generally be taxed at 20%. So your tax savings would be 20%. Better! And if harvesting short-term losses would allow you to offset up to $3,000 (or $1,500) of ordinary income, the tax savings will be at your regular rate of up to 35%. Much better!

Get Out the Calculator
As you can see, the exact impact of harvesting losses between now and year-end depends on your exact circumstances. So I recommend hauling out your records, your calculator and the 2003 version of Schedule D of Form 1040 to figure out where you stand before doing any serious harvesting. (You can print out a draft copy of Schedule D here.) Once you know where you stand, here's my advice, again in shorthand:

  • Go ahead and harvest long-term losses before year-end if they would offset short-term gains, up to $3,000 (or $1,500) of other ordinary income, or pre-May 6 long-term gains. In this scenario, your tax savings from harvesting long-term losses will generally be 20% or better.

  • If harvesting long-term losses before year-end would only offset post-May 5 long-term gains, your tax savings will generally be only 15%. Consider postponing some or all of your harvesting activities until next year if that would save taxes at a higher rate.

  • Go ahead and harvest short-term losses before year-end if they would offset short-term gains, up to $3,000 (or $1,500) of other ordinary income, or pre-May 6 long-term gains. Your tax savings will generally be 20% or higher.

  • If harvesting short-term losses would only offset post-May 5 long-term gains, your tax savings will generally be only 15%. In this case, consider postponing some or all of your loss-harvesting sales until next year.

    Consider Buying Equity Mutual Funds With Big Past Losses
    I've traditionally given you one piece of year-end tax planning advice that goes like this: Don't buy into mutual funds near year-end if you're investing via a taxable account. The reason? You might jump into the fund just in time to receive this year's taxable distribution of accumulated income and capital gains (they usually occur in December). In this situation, which is known as "buying the distribution," you get taxed on profits that were earned by the fund before you even owned your shares. Bad idea.

    Things have really changed. Now, my traditional advice no longer applies in many cases. That's because despite recent upswings, many equity funds still have whopping big losses left over from 2000-02. Some of these losses were realized when funds bailed out of loser stocks; some are in the form of unrealized losses from underwater positions that are still owned to this day. In either case, funds with big losses can now earn big capital gains without having to make any taxable distributions to shareholders. In other words, a fund's past losses can shelter its future capital gains just like past losses that you've incurred personally can shelter your own future gains.

    Bottom line: Investing in a fund with big losses near year-end has no tax downside. In fact, buying in now could actually lock in a valuable tax-deferral advantage for you.

    To cash in on this opportunity, you need to identify funds with large negative PCGEs (potential capital-gains exposure). For instance, the assets of a fund with a -50% PCGE can go up by 50% without triggering any taxable distributions. So this fund has a tax-deferral advantage compared to other funds with positive or less-negative PCGEs. This information is available at the Morningstar Web site, where you can track down lots of funds that have big negative PCGEs. This statistic is listed in the "Tax Analysis" section of the Morningstar fund reports.

    But be warned: Buying into bond funds before year-end could expose you to the unwanted taxable distribution problem. Some of these funds have done very well and may therefore make taxable distributions between now and year-end. These funds will have positive PCGEs.

    Give Appreciated Stock Away; Sell Loser Shares
    After the 2003 Act, high-bracket folks should consider giving away appreciated stock to their lower-bracket children and grandchildren. For instance, say your child is approaching college age or is already there. You can give her up to $11,000 worth of appreciated stock between now and year-end without any adverse gift- or estate-tax consequences under the annual gift-tax exclusion privilege (assuming you didn't make any other gifts earlier this year). You and your spouse can together make a joint gift of up to $22,000. This maneuver reduces your taxable estate in the best possible way: By removing appreciating assets from the tax collector's clutches.

    On the income-tax side, your child can sell the appreciated shares and pay only 5% to the IRS (assuming she's in the 10% or 15% rate bracket, as she almost certainly is). She can use the after-tax sales proceeds to cover her college expenses. For this idea to work as advertised, you and your child must together hold the appreciated shares for more than one year. Remember: The same ultra-low 5% rate also applies to qualified dividends collected on stock held by your child.

    On the other hand, please don't give away loser shares. Instead, sell them, claim the resulting capital-loss write-off on your 2003 return, and give away the cash sales proceeds to your kids or grandchildren.

    Prepay and Bunch Deductible Expenses
    One of the fundamental precepts of tax planning is that it's almost always better to pay taxes later rather than sooner. Deferring your taxes by prepaying deductible expenses near the end of this year makes good sense if you expect next year's tax rate to be the same or lower than this year's. (Unless things change unexpectedly, the current federal income-tax rate structure will apply next year too.)

    The easiest deductible expense to prepay is your Jan. 1 mortgage bill. Accelerating the payment gives you 13 month's worth of deductible interest in 2003. You can pull the same trick with your Jan. 1 vacation home mortgage payment. Of course, if you prepay this year, you must continue the policy in future years. Otherwise, you'll have only 11 month's worth of interest in the first year you stop.

    Next up on the prepayment menu are your state and local income and property taxes. In particular, consider prepaying estimated state and local income-tax installments that are not actually due until early next year. But don't prepay these taxes if you know you'll owe the alternative minimum tax (AMT) for 2003. Why? Because state and local income and property taxes are completely nondeductible under the AMT rules. So prepaying does absolutely no good if you're unlucky enough to be in the AMT mode.

    Next, try to bunch together expenses that are subject to limits based on your adjusted gross income (AGI). The two prime candidates are unreimbursed medical expenses and miscellaneous itemized deductions. Medical costs are deductible only to the extent that they exceed 7.5% of AGI. Miscellaneous deductions -- for investment expenses, fees for tax preparation and advice, and unreimbursed employee business expenses -- count only to the extent they exceed 2% of AGI. If you can bunch two years' worth of these types of expenditures into a single tax year, you'll have a fighting chance of clearing the AGI hurdles in alternating years (instead of never). For example, you could prepay your tax adviser for next year's work. Unfortunately, this bunching strategy rarely helps AMT victims. Medical expenses must exceed 10% of AGI to be deductible for AMT purposes, and miscellaneous itemized deductions are completely disallowed under the AMT rules.

    Finally, the 2003 Act gives some joint filers yet another incentive to follow the prepaying and bunching strategies. That's because the 2003 joint-filer standard-deduction amount was increased to $9,500 (up from $7,950). So if your total itemized deductions would fall slightly under $9,500 in the absence of planning, you should try to bunch and prepay deductible expenses in alternating years. Start with this year! That way, you can itemize in alternating years and claim the increased standard deduction amount every other year. Over time, your cumulative write-offs will be higher and your cumulative taxes will be lower. And that's what tax planning is all about.