Tips for Managing Taxes

by Douglas Gerlach

Once you know how capital gains and losses (and taxes) are determined, you can make better decisions about keeping your tax burden to a minimum. Remember: every dollar that you pay in taxes can reduce the overall performance of your portfolio.

Here are six strategies you can use to keep more of your money in your pocket, and out of Uncle Sam's!

1. The easiest way to avoid capital gains is to never, ever sell! One big advantage of being a long-term investor is that you can minimize your investment taxes. In fact, the ultimate long-term investment strategy is to hold stocks until the day you die. Your heirs will then receive your shares with the cost basis set at the time of your death- with no capital gains taxes to pay. (Estate taxes may be due, if applicable.)
2. When you do need to sell, always consider the holding period first. Of course for most of us, never selling might be impractical. But you can reduce the impact of taxes if you think before you sell. For instance, if you've owned a stock for eleven months, you might hold it for another month before selling, thus triggering a long-term instead of short-term capital gain. If you need bucks for some other purpose, you might decide to sell shares with the largest amount of long-term capital gains in order to generate the highest amount of ready cash. If keeping your taxes to a minimum is important, sell shares with smaller capital gains instead.
3. Consider investing in stocks that concentrate on growth. These stocks tend to pay low or zero dividends. The idea is that you build wealth through stock appreciation rather than accumulated dividends, since dividends are taxed in the year that you receive them and at a higher rate than capital gains. While high-yielding stocks might seem attractive, they're usually the choice of people who need current income, such as retirees, and not investors who are building long-term wealth.
4. Offset capital gains with capital losses. If you sell stocks at a loss, you can subtract those losses from your gains, reducing or even eliminating any capital gains taxes. Part of your annual planning should be to consider selling stocks to generate a capital loss equal to the capital gains you have for the year. In addition, if you have excess losses, you can deduct capital losses of up to $1,500 a year ($3,000 for married couples filing jointly) from your ordinary income. Any additional capital losses can be carried forward to tax returns in future years.
5. Give away stocks and eliminate your capital gains. If you have family members to whom you'd like to give cash, consider making a gift of stock instead. You can give up to $11,000 a year to any number of individuals without incurring gift taxes. (If you give more, you'll need to file a gift tax form with the IRS and the amount will either be taxed or deducted from your lifetime gift tax exclusion, currently $700,000.) The recipient takes over the original cost basis of the shares and will be liable for capital gains when they sell. But just remember, you'll never get rich if you give away your fortune before you even make it!
6. Give shares to a charitable organization. For example, if you make an annual $1,000 gift to a charitable or educational organization, you could give $1,000 worth of a highly appreciated stock instead. If your cost basis in that stock was $500, your cost of the gift is $500, and you'll also get a deduction for a charitable contribution of $1,000 on your tax return. Plus, you avoid paying taxes on the $500 of gains you would have owed the IRS if you had sold the stock instead of gifting it.
7. Invest in an IRA or other qualified retirement account. These accounts are tax-deferred, which means that you won't pay taxes on capital gains during your working years. In fact, you won't have to worry about any taxes at all in these accounts until you start making withdrawals in your retirement years.

One final item: all of these strategies share an underlying need for you to keep good records of all of your investing transactions. Record-keeping software like Microsoft Money or Quicken can help you satisfy the IRS as well as make solid, tax-wise decisions.