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Don't Wait To Harvest Your Losses

The end of the year is the typical time for investors to “harvest” capital losses to offset their capital gains.  In fact, you normally might wait until the last few days of the year to pick and choose the losers that are ripe for selling.  However, this year you might consider selling earlier than usual, especially if you expect to be in a high tax bracket.

Here’s why:  On the federal tax level, the top income tax rate for ordinary income—including short-term capital gains on securities held for a year or less—increases from 35% to 39.6%.  In addition, the maximum tax rate on long-term capital gains for upper-income investors jumps from 15% to 20% for those in the same tax bracket.  Finally, a new 3.8% Medicare surtax takes effect in 2013 and may apply to investment income of some taxpayers.

When you combine these tax increases, your effective tax rate on short-term capital gains could be as high as 43.4%, while you might pay an effective tax rate of 23.8% on long-term gains—not even taking state and local income taxes into account.  If you’re in this position, you won’t want to leave tax planning to chance during the last few weeks of the year.  If an opportunity presents itself to cash in a losing stock position earlier, you might seize it.

Example:  Suppose you recognized a $10,000 gain earlier in the year from the sale of a stock you had owned for 10 months.  But you own a stock that currently shows a $10,000 paper loss.  Based on your estimates, you will be in the 35% tax bracket for 2013 and any capital gains you have this year will be subject to the 3.8% Medicare surtax.

If you do nothing—in other words, you don’t sell that stock or any other assets at a loss—your short-term capital gain will be taxed at the 35% rate, plus you’ll owe an additional 3.8% surtax for a total of $3,880 in federal taxes on your $10,000 gain.  But if you sell the stock at a $10,000 loss right now, you effectively wipe out the tax for both the short-term gain and the Medicare surtax.  Thus, your tax bill is zero.  (Of course, other gains and losses incurred during the year will affect your tax liability).

The main principle of this approach is to take your losses when you can get them.  Then, when the end of the year finally rolls around, you can reassess your situation.

There is one last point to remember:  Under the “wash sale” rule, you can’t claim a loss on the sale of securities if you reacquire substantially identical securities within 30 days of the sale.  Selling stock at a loss before year-end gives you more flexibility to avoid that harsh tax result.  For example, you might sell a stock in October, wait more than 30 days and reacquire the same stock in December if you think it will rebound.  But factor in all the implications, not just taxes.

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