A Killing On Wall Street Can Lead To Getting Killed At Tax Time

By Megan E. Corcoran

Making a killing on Wall Street can really hurt when it comes time to pay Uncle Sam, but with a well thought-out strategy, a savvy investor can minimize tax pain and make the most of a profitable year.

“When tax time comes you can’t avoid it, you have to pay the piper,” says Karen Altfest, a financial planner at New York-based L.J. Altfest & Co., “but there are things you can do to weaken the tax bite.”

Tax Strategy Lesson 1: Good Things Come To Those Who Wait.
“Every investor should make sure that anything being sold with a gain was held for a year or more or else gains may be slapped with more than a 20% federal tax,” says Altfest.

Gains on stocks held for less than a year are subject to taxation at an investor’s income tax rate–which can be as high as 39.6 % (at the federal level). But long-term capital gains are only subject to a 20% tax rate; so holding your position for at least a year can save you a substantial amount.

This doesn’t apply to holdings in tax-deferred accounts, such as an Individual Retirement Account (IRA), 401(k), or Keogh since withdrawals from these accounts will be taxed as ordinary income no matter what. However, there’s a significant advantage to trading in a tax-deferred account: the gains and losses are tax-exempt until the money is withdrawn. So you could realize significant gains within the account without paying taxes on the earnings for some time.

Moreover, the tax deferral has a chance to compound over time, lessening the final tax consequence. Just keep in mind; if you lose money while trading in your IRA, you cannot deduct tax losses in a retirement account to offset capital gains or ordinary income. And remember that your IRA is designed to fund retirement, so don’t go betting the farm.

Figuring out ways to postpone handing money over to the IRS is a big part of developing a tax strategy. Eventually you have to bite the bullet, but the goal is to earn more income from the money in the meantime. An obvious way to postpone paying taxes is to delay earning income until the New Year. Many investors wait until January 1 to unload appreciated stocks or postpone collecting ordinary income. “If you wait until the New Year, you postpone your tax bill for a year,” says Altfest.

Tax Strategy Lesson 2: Winners Need Their Losers.
Nobody likes to be a loser, but it can come in handy to have some losses when it’s time to pay taxes. “Generating losses in your portfolio to offset gains can help with the overall tax liability,” says Janine Racanelli, a Vice President at J.P. Morgan’s Private Banking Wealth Strategy Group.

Taxpayers are allowed to use losses to offset unlimited capital gains and up to $3,000 of other income, so it’s worthwhile to consider selling losing stocks. But be sure to consider the long-term value of the stock and weigh that against the benefit you’ll receive by claiming a deduction for the loss. And be wary of the wash-sale rule, which prohibits investors from selling a security to create a loss and then quickly repurchasing it within 30 days before or after the sale.

Another way to offset tax liability is to spend money to get more deductions. That doesn’t mean you should run out on a shopping spree, but spending can help offset income and capital gains. For example, prepaid interest is deductible, so if a home mortgage payment is due by January 15, consider making it before December 31. And medical expenditures exceeding 7.5% of your adjusted gross income qualify for deductions.

“Even investment advice is tax deductible as long as it exceeds 2% of adjusted gross income,” says Altfest.

Contributing to your favorite charity is a great way to compensate for capital gains or income. Furthermore, you double your pleasure when you donate appreciated property, like stocks, because you get the deduction for the property’s full market value, plus you avoid paying tax on the capital gains you would have had if you sold the property outright.

“It’s very common for individuals with capital gains to give the stock to charity as opposed to selling it. That way they get income deduction based on fair market value, and neither party pays a capital gains tax,” says Racanelli.

“Even if you give clothes to the Salvation Army, get a receipt and an estimate of what the donation was worth tax wise, so you can take a deduction,” says Altfest.

In an effort to keep money out of the clutches of the IRS, you may even opt to save money in your child’s name, under the Uniform Gift to Minors Act, to take advantage of the child’s lower tax bracket. Just remember, however, when children turn 18, the money is all theirs.

“If you do want to give to a child to lower taxes, the best time to do it is when the child is over 14 years of age since that’s when they fall into a lower tax category,” says Altfest.

And many investors consider it a helpful investment strategy to include municipal bonds (munis) in their portfolio. Munis add diversity to your portfolio and profit without taxes since most are exempt from federal, state, and local income tax.

“Taxes should not be the only thing to steer investments. You need to look at both investment and tax aspects carefully,” says Altfest. Strategies vary according to age, income, and individual situation–so it’s necessary to estimate future income, deductions, credits, and exemptions in order to formulate a tax wise strategy. The real lesson is that it may require some work, but an ounce of prevention is worth a pound of cure at tax time.