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Many of us are sitting on stocks and funds whose losses are so
big that it's depressing. Take heart. The loss may be worth more than the
stock. If so, here's how to benefit from your misfortune.
After another lousy year on Wall Street,
investors are tallying up some depressing negative returns. But before you
weep into your year-end statements, take heart: With some careful
planning, you may be able to use your losses to your benefit.
Losses that you incur when you sell your
investments -- whether stocks, bonds or other securities -- can be used to
offset gains, dollar for dollar.
“What gains?” you might ask. Indeed, many
people who started investing in recent years are sitting on piles of
losses but have no gains to offset this year.
“But it still can make sense to realize some
losses,” says Lisa Osofsky, a tax specialist at M.R. Weiser in New York.
For one thing, you can deduct up to $3,000 of
losses against your adjusted gross income if you have no gains or if your
losses exceed your gains. And any unused losses can be carried forward
indefinitely to offset gains or deduct against income in future years.
Say you realized $5,000 in long-term gains this
year and $12,000 of losses. Without the losses, the $5,000 gain would be
subject to the 20% long-term capital gains tax. But the losses wipe out
the gain -- and your capital gains tax bill. Of the excess $7,000 loss,
$3,000 of it could be deducted against this year’s income on your tax
return. The balance, $4,000, could be carried forward to another year.
In some cases, it’s more beneficial if you
have no gains and you deduct losses from your income. “You can get more
mileage out of your losses that way,” Osofsky says. That’s because
marginal income tax rates can be much higher than long-term capital gains
tax rates -- up to 38.6% vs. 20%.
For example, if you’re in the 27% tax bracket
and you deduct $3,000 of your losses from your income, that would mean an
$810 in savings you can use now. If you used the $3,000 to offset
long-term gains, you would save yourself just $600.
How to turn a tax loss into cash
In future years, to turn that $3,000 deduction
into cash that you can use for more promising investments, you can adjust
your withholding on your W-2 so that less of your paycheck goes to the
government and you can pocket more. For this year, if you take the
deduction, you will either owe less when you file your tax return or get a
refund.
What should you do with your extra cash? Steven
Enright, an investment adviser in River Vale, N.J., suggests staying away
from individual stocks and choosing a steady all-weather mutual fund
performer. Enright likes Oakmark Equity Income, a fund with about 60% in
stocks that has not had a down year since it was launched in 1995, Enright
says. In 2000, when the S&P 500 was down 9.53%, Oakmark was up 20%.
And in 2001, it was up 18% vs. the S&P’s 13.63% loss. Through
November this year, the fund was down 1.6%, but the S&P was down
18.45%. During bull market years, the fund is likely to lag the S&P,
“but the bottom line is it will never get killed,” Enright says.
To sell or not to sell
The big question, of course, is whether it makes
sense or not to sell shares to realize losses. “If you sell, it has to
make sense from an overall economic standpoint, not just from a tax point
of view,” says Bernie Becker, tax manager at Bederson & Co., a
Butler, N.J., accounting firm.
If you’re holding a true dog that shows few
signs of recovering, it may make sense to stop the bleeding.
But if there are good prospects for a company
despite a recent drubbing of its share price, it can be a tricky call.
"A lot depends on your time frame. Companies like WorldCom and UAL
Corp., the parent of United Airlines, may end up being OK in the long run,
but you may decide you don't have time to wait. Then you should dump your
shares," Osofsky says. "Other companies, like Wal-Mart Stores
and others in the retail sector, have gotten hit, but they're probably
going to have steady solid growth so they may be worth holding on
to."
If you’re approaching retirement or need your
money in less than five years, you may want to dump a loser even if it
promises eventually to rebound. What you’re doing is engaging in
preservation, and that’s an honorable move to make, Osofsky says
“But if you’re 30 or 40, and the stock is in
your retirement account, leave it alone.” Let time do its magic.
A final test before selling: “If you paid
$5,000 for an investment now worth $1,000, ask yourself this question: If
you had the $1,000 to invest today, would you buy that investment? If not,
then it might be time to sell it,” Osofsky says.”
Limit your cost basis
If you do decide to sell shares at a loss, and
you are sitting on gains, this might be a good opportunity to realize some
of the gains even on stocks you would like to hold for the long term.
“It’s an opportunity establish a higher cost basis on stocks you have
been holding for years that were purchased at very low prices,” Becker
says.
Say you inherited some Johnson & Johnson
stock while you were in college 20 years ago, and you want to hold a
position in the company for the long term. The stock has appreciated
significantly since then -- roughly 15% a year BEFORE dividends and
DESPITE a recent plunge in its price. You can sell some shares, offset the
gains from your losers, so there are no tax consequences.
Then, you can buy back shares and establish a
higher cost basis. “When the stock does go back up and you eventually
sell it, you will have less of a gain to report,” Becker says.
The tricky part is that you cannot buy the stock
back immediately. Under so-called wash-sale rules, you can’t buy a
security back within 30 days after dumping it. If you do, you lose the
chance to claim the loss until you unload the shares you repurchased.
So if you use the strategy to establish a higher
cost basis, you run the risk that the stock's price will rise
significantly during the 30 days before you can buy back shares.
If it’s a sector or industry you’re
interested in more than a specific company, you have more flexibility
under wash-sale rules. With individual stocks, you can buy back a similar
stock in the same industry --for example, if you dump Pfizer you can buy
Eli Lilly. If you unload a fund, you can buy back a similar fund as long
as it is managed by a different fund family.
You also have to consider the distinction
between short- and long-term losses before you take advantage of your
losses. Short-term losses, which are those realized on investments held
for less than 12 months, can be used to offset either short- or long-term
gains. The same goes for long-term losses, which are realized on
investments held 12 months or longer.
But there are some restrictions: If you have
short-term losses, you must first use them to offset any short-term gains.
Any leftover short-term gains can be used against long-term gains.
Similarly, long-term losses must first be matched with long-term gains.
2003 small business aide
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