With the S&P 500 Index ($INX) down about 40% from its late 2007 peak, you've probably got some significant losses in your portfolio.
Here's a little solace: That red ink can help you keep a little more black ink when Uncle Sam tries to scalp you next April.
At tax time, your investment losses can be used to offset your investment gains, and they can offset up to $3,000 in ordinary income you'd otherwise pay taxes on. That's particularly nice this year, when gains have been hard to come by.
If your losses exceed that figure, they can be carried forward and deducted in future years, when they will be more valuable than they are now.
You can also use the tax code to wrestle a few more bucks away from Uncle Sam if you're sitting on profits from the past year (or past years). That's because taxes on investments will go up; President-elect Barack Obama has vowed as much. So capital gains are more precious now than they will be in the future.
That makes this an excellent time for a wholesale cleansing of your portfolio, or at least the part of it that sits in taxable accounts. Take your losses, book your profits, trade your funds for better ones, and put your money where it will benefit the most from what we hope will be a better year ahead.
Mind the rules
There are traps to avoid when managing investment taxes, and if you've generally invested long term or in 401(k) or other tax-free accounts, it's an area that may be new to you.But the rules are intended to prevent fraud, so you can navigate them without difficulty. Perhaps the trickiest part of accounting for taxes on investments is that it's impossible to get advice from the Internal Revenue Service, and your accountant can't do much better unless he or she is also a skilled financial adviser.
- For more tax tips, watch the video to the right.
But this simple guide will help. And mutual fund investors have a particularly easy job of it. The key fraud rule prohibits you from booking a loss when you sell an investment and buy something else within 30 days that is, in the words of the IRS tax-wash rule, "substantially identical." Few funds are.
You can buy an identical fund if your object is to take gains rather than report losses. This happens to be one of the few years when that move makes sense, because you can likely take that profit and use your loss to avoid a tax bite.
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A lawyerly rule
"Substantially identical" is a lawyer's phrase; that is, it has a clear meaning only to lawyers, not to ordinary people. "Identical" has a clear meaning: Two things are either identical or they are not; the relationship is binary, off or on.In a world where words had meaning, however, there would be no lawyers. That's a paradise we do not inhabit. "Substantially identical" creates room in which to weasel around. Indeed, that is the point; this is what makes work for weasels.
So if you call the IRS and ask for advice, the person on the line won't have any, because he or she doesn't know fudge about individual investments. Neither, probably, does the person who prepares your tax filing. The onus is on you.
That's because a weasel -- sorry, a lawyer -- could argue (and an IRS lawyer would argue, successfully) that you had flouted the rule by selling an S&P 500 Index fund managed by some insurance company and buying the Vanguard S&P 500 Index fund (VFINX). Yes, the Vanguard fund will have lower expenses, a slightly different methodology of indexing and superior long-term performance, so it is by no means identical to any other S&P 500 Index fund. But you'd lose the case.
Video on MSN Money
The fund industry's big problemsMSN Money blogger and Strategy Lab trader Andrew Horowitz says the mutual fund industry's problems aren't going away anytime soon.
That is, however, just about the only way a mutual fund investor can run afoul of this wash-sale rule. Stressing that I am not, in case you haven't already realized this, a lawyer (or an accountant), the rule does not prohibit selling almost any actively managed mutual fund and buying another fund actively managed by a different company.
All you need to be able to demonstrate is that the new fund employs a different strategy than the old one, the evidence of which is that it has different characteristics. Even if both funds invest in similar companies, they will have different average market capitalizations, different sector and individual-security weightings, and other significant differences that a side-by-side comparison will reveal. I'll give you examples of such comparisons below.
Does this mean that index investors, which includes those of us who invest in exchange-traded funds, cannot avoid flouting the rule? No. Assuming you swap funds that track different indexes -- even if both indexes benchmark the same marketplace -- and have other characteristics that distinguish them from each other, you are on firm ground.
Continued: Trade growth for value
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