I’ve seen too many people lose too much money doing something fancy to save money on taxes. This might be holding onto a stock because selling would mean paying taxes, only to see the stock fall enough to far exceed the taxes that would have been owed. The worst one I saw was a women mentioned in The Wall Street Journal who borrowed money against her shares of a dot-com start-up company rather than simply selling shares to avoid taxes. In the end she went from a paper gain of a million dollars to owing her brokerage company a few hundred thousand dollars from the loan she took out against her shares when the company’s stock fell to earth.
That said, you should use taxes as a secondary factor once you have already decided to buy or sell a stock. For example, you should hold mutual funds that pay a large amount of interest or dividends, or that sell shares and realize gains frequently, in an IRA or a 401K account so that you won’t lose as much money to taxes each year. You should also use the strategy of buy-and-hold when it comes to individual stocks rather than trying to buy and sell since, in addition to it being a lot easier to pick stocks that will do well over a long period of time than picking those that will do well over a few weeks or months, holding stocks naturally delays paying capital gains taxes so that your returns can compound. The capital gains rate is also (often) at a lower rate for stocks held a long time than for those traded frequently.
Another effective strategy is to pair winners and losers together when you do sell. Let’s say, for example, that you have a stock that has gone up five-fold and now dominates your portfolio. You decide you’d like to sell a portion of the position since you’d hate to lose it all should something happen at the company. You also have a stock that just hasn’t performed and you realize that it was a mistake to purchase. If you sell the stock in which you’ve lost money in the same year when you sell the winner, you can offset the gain on the winning stock with the loss on the losing stock. Again, you’ve decided to make both of these sales anyway. You just make them in the same year to save on taxes.
What if you have a losing position but no gain? You can actually deduct a portion of your regular income against the loss ($3,000, last time I checked), and you might even be able to carry-over the loss into future years and deduct against future gains. (Note this is something to discuss with an accountant since this can get tricky and making a mistake can cost you thousands of dollars.)
In general it is a good idea to periodically spend time with an accountant and discuss tax strategies since the rules are often difficult to follow. If you something in one way, you might pay more on taxes than you would have if you had done it a different way and filed the right forms. There is also often more that can be done upfront when trying to save on taxes than can be done after the fact. A good accountant is well worth the money spent.
And again, it would be great to have The Fair Tax so that taxes wouldn’t matter at all. Check it out at www.fairtax.org.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.