For many physician-investors, sorting throughthe complex IRS rules regarding investmenttaxes can be a nightmare. Pitfalls abound and the penalties for evensimple mistakes are severe. This year, as you beginplanning for tax season, consider the myriad waysyou can keep a little more money in your pocket—where it rightfully belongs.
Losing Winning Stocks
Normally, when you sell a profitable investmentyou pay taxes on the gains. To decrease capital gainstaxes, you can sell off losing investments, thereby offsettinggains and losses. This is known as harvestinglosses. For example, let's say you own two stocks. Youhave a $1000 gain on the first stock and a $1000 losson the second one. If you sell the profitable stock,you'll pay taxes on the gains. If you sell both stocks,however, your $1000 loss will offset your $1000 gainand you won't owe any taxes.
Sound like a good plan? It is, but it can get a bitcomplicated. Under the "wash sale rule,"you can'tdeduct the loss if you repurchase the losing stockwithin 30 days of sale. But not only are you prohibitedfrom repurchasing the losing stock, you are alsoprohibited from purchasing stock that is consideredidentical to it. Therefore, before you start harvestinglosses, make sure this strategy is a good fit with youroverall investment goals.
Mutual Fund Troubles
While calculating gains and losses from individualstock sales is usually straightforward, calculating gainsand losses from mutual funds poses more of a problem.Since this can be tricky, it pays to keep meticulousrecords and consult with a tax expert.
Most physicians are long-term investors who intendto hold their mutual funds for years. As such, they'reoften unpleasantly surprised when they're forced to payshort-term capital gains taxes on annual fund distributionseven though they didn't sell a single share. Theproblem stems from the fact that mutual funds distributetheir short-term capital gains to shareholders, who arethen saddled with the tax bill. This can take a big biteout of your returns, since these short-term capital gainsare taxed as ordinary income.
One solution is to buy tax-efficient mutual funds.These funds try to provide strong annual returns aswell as minimize shareholder taxes by limiting portfolioturnover and capital gain distributions.Another option is to buy exchange-traded funds(ETFs), which are passively managed funds thattrade like individual stocks. They provide diversificationlike mutual funds, but without the typicalexpenses and tax inefficiencies.
If you decide to stick with traditional mutualfunds, avoid buying shares before a scheduled distribution.If you don't, you'll be stuck with paying taxeson the full amount.
Home Sweet Home
Holding the right assets in the right account can saveyou thousands of dollars in unnecessary taxes.Generally, investments that produce lots of taxableincome or short-term capital gains should be held in tax-advantagedaccounts. Whereas, investments that paydividends or produce long-term capital gains should beheld in traditional accounts.
Let's say you own shares of Duke Energy. Thisinvestment will generate quarterly dividends, which willbe taxed at 15% or less, and long-term capital gains,which will also be taxed at 15% or less. Since theseshares of stock already receive favorable tax treatment,there's little benefit to sheltering them in a tax-advantagedinvestment account.
On the other hand, most treasury and corporatebond funds produce interest income. This income doesnot qualify for special tax treatment, so you'll pay taxeson it at your marginal rate. Unless you're in a low taxbracket, holding these funds in a tax-advantagedaccount makes sense; it lets you defer tax payments orpossibly avoid them altogether.
is president of Flagship Capital
Management, an independent fee-only portfolio
management and wealth advisory firm in
Colorado Springs, Colo. Mr. Twibell welcomes
questions or comments at 719-785-4832 or
David A. Twibell