Holiday Cheer: Part 1

The year is winding down quickly and as I peruse the calendar, I realize that there is not much time to take advantage of some year-end financial action items. To help you maximize the time left in the year, over the next few weeks, I will provide tips for end-of-year planning, which hopefully will allow you to save or make more money before Santa arrives.

Today we’ll start with one of the best places to find money: in your taxable portfolio. While 2007 should have been a pretty good year for most investors, you may also find some assets that still have losses from the bad old years. Now is a great time to assess your portfolio and position it for the year ahead. Obviously taxes are not the only reason to buy or sell an investment, but if you can reap tax advantages while diversifying your portfolio or adjusting your asset allocation, you should definitely do so.

Consider selling the following assets:
Securities that have performed well this year, but whose prospects for continued growth are limited
Securities that have risen, causing your overall asset allocation to be different than your risk tolerance would suggest
Mutual Funds that have large capital gains distributions

While it makes sense to sell some losers, not all losers are created equal. Try not to alter your overall asset allocation strategy by selling too many investments. The best way to do this is to replace the loser with a similar asset, without facing the “wash-sale rule,” which is the IRS rule that ensures that you are not taking losses in one security as you invest in a “substantially identical” investment within 30 days of your sale. One way to avoid this is to replace a traditional open-ended mutual fund with a cheaper exchange-traded fund, thereby taking your loss and reducing the fee you pay for your investment.

Additionally, if you are thinking of dumping out of a loser mutual fund, do so quickly. Most mutual funds distribute annual capital gains during the month of December so if you are planning a year-end sale, get going! Remember that even those mutual funds that have gone down this year could still distribute long-term capital gains. Additionally, some funds are distributing large gains, while other similar funds may not. Consider swapping funds to reduce taxable distributions.

Beware of potential tax law changes: Until 1997, the long-term (investments held for over one year) capital gains rate was 28% and was then reduced to 20% until 2003. Since the tax cuts of 2003 were enacted, the top rate of long-term capital gains has been 15%, but it's set to rise to 20% in 2011. While it would be nice if capital gains rates stayed at these rock-bottom levels, it is probably more realistic to assume that rates will increase in the future. Many tax experts expect that if a Democrat assumes control of the White House, he or she will move quickly to raise the top rate even higher than 20%, perhaps back to 28%.

While I am never one to let the tax tail wag the investment dog, I have been advising clients to consider selling off concentrated low-basis positions in 2007 and 2008 to capture the current rate, as long as selling the asset will better diversify the portfolio. The potential window of opportunity could save significant dollars and perhaps might push you to do something that you have been meaning to do for some time (“I really should sell off some of Nana’s IBM, but I hate to pay the taxes!”) You should consult your advisor or accountant to discuss the implications of executing this strategy. Clearly investors should sell assets only after careful consideration of individual circumstances.

This is just a start—next week, we will discuss additional year-end strategies to boost your holiday cheer!