How to Turn Your Investment Lemons Into Lemonade in the Next Two Days

December 29, 2011

We usually wait until April 15th to worry about taxes, but the time to do something about them is mostly well before that. Some examples include contributing to your employer’s retirement plan and flexible spending accounts. But there is also one thing that you can do right now if you have investment losses outside of your retirement plan.(I know I do and if you have any taxable investments, you probably do too). Here’s how you can turn losses into extra cash on April 15th:

1) Sell them before the end of the year (today or tomorrow). Yeah, it’s usually not a good idea to sell an investment just because it’s down but this is an exception and you’ll see why.

2) Take the proceeds and reinvest them into a fund in the same category as the investment you sold, but not one that’s substantially identical. For example, if you sell a large cap stock fund then buy another large cap stock fund, but don’t sell a Vanguard S&P 500 index fund and buy a Fidelity one, since they’re substantially identical even though they’re from different companies. By doing this, you can still benefit if that area of the market does well after you sell.

3) After 30 days, you can then go back and move your money back into the original investment if you prefer. This helps you avoid the wash sale rule, which means if you buy a substantially identical investment 30 days before or after you sell it, then when you sell the investment again, you’ll end up paying taxes as if the first sale never happened and you won’t be able to take the next step.

4) When you file your taxes, write the losses off against any capital gains you have that year. Up to $3k of excess losses can be deducted from your regular taxable income. If you have at least $3k of losses and no capital gains, and you’re in the 25% bracket, that could save you $750 in taxes.

5) Finally, you can carry excess losses above that $3k to future years. If you have a lot of losses, that can save you quite a bit of money over time.

Some people will argue that you won’t really benefit since you’ll just make it up in higher capital gains taxes when you eventually sell.

There are a couple of counter-arguments to this though. The first is that the capital gains rate is higher than your regular income tax rate. In other words, yes you might have to pay a 15% tax on that extra gain, but you might also be able to deduct those losses at 25% so you pay 10 percentage points less in taxes. Second, you can avoid the capital gains tax by gifting investments after they’ve gone up in value, instead of cash. If you give them to a charity or a child, they may not have to pay taxes on the gain either. Finally, you can live off the dividends in retirement and never sell at all. When you pass away, your heirs can inherit those investments tax-free.

All of this is one of the main reasons that volatile investments, like stock funds and especially individual stocks, should be the last to be sheltered in your retirement accounts. If you have a large complex account, you may want to hire a money manager to do this for you. In any case, don’t cry when your investments eventually turn into lemons (and every type of investment will have their turn). Just turn them into lemonade (or whatever you want to buy with that extra cash on April 15th).