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Investing Specialists

Dos and Don'ts for Year-End Tax Planning

Tips for managing capital gains distributions, harvesting tax losses, and taking required minimum distributions.

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You sometimes hear that you should conduct your portfolio maintenance--checkups, rebalancing, tax-loss harvesting, and so forth--at year-end.

But in reality, waiting until late December is apt to be too late if you're aiming to minimize your tax bill. You may lose your chance to act pre-emptively to avoid capital gains distributions from your mutual funds, for example. And the longer you wait, the more you court the risk that you won't conduct these year-end portfolio maneuvers at all. After all, December is often a busy month, period. 

That's why now is a good time to start thinking about your year-end investment-related tax strategy. Holiday mania has yet to descend, and you have time to think through which moves make sense from both a tax and portfolio perspective. 

Here are some key dos and don'ts to keep in mind as the year winds down. 

Do: Consider pre-emptively selling if you planned to do so anyway.
I think it's going to be a doozy of a capital gain distribution season, especially from equity mutual funds. After a six-year stock market rally, many funds have hefty capital gains on their books from having unloaded appreciated shares, and they have few losses to offset them. Those gains, in turn, must be distributed to shareholders. Further adding to the potential for capital gain distribution pain is that many actively managed equity funds have been in redemption mode as investors have switched to passive products; that means those distributions will get dished out across a smaller shareholder base of active-fund owners who stayed put. If your plan was to lighten up on a position or sell out of it altogether because doing so makes sense from an investment standpoint, consider making your trades before capital gain distribution season begins in earnest--usually in early December. Funds will begin posting estimates of their anticipated distributions within a month or so; scout out your fund company's website for the latest information. 

Don't: Sell pre-emptively without considering your own tax position.
Selling pre-emptively to avoid an impending capital gain distribution isn't always a good idea, though. If you unload shares to dodge a distribution, you run the risk of triggering another tax bill instead: capital gains taxes on your sale. And if your shares have appreciated substantially since you purchased them, those gains could handily exceed any savings you realize by dodging the impending distribution. Thus, it's important to make sure that you're letting an investment's fundamental merits, rather than tax matters alone, drive your decision-making. 

Do: Scout around for tax-loss sale candidates.
Another way to blunt capital gains pain is to unload securities that are trading below your purchase prices. You can then use those losses to offset your capital gains or, if your losses exceed your gains, to offset up to $3,000 in ordinary income. Stocks are generally up this year, but you still may be able to identify laggard holdings here and there. In fact, more than 6,000 individual stocks in Morningstar's database have posted losses of more than 10% over the past year, including widely held mega-cap names like  Amazon  (AMZN),  Ford (F) and  General Motors (GM), and Samsung Electronics (SSNLF). It may be harder to find mutual funds that are in the red over your holding period, but energy and commodity funds could be ripe for pruning. If you've selected the specific share identification method for calculating cost basis, you can take a surgical approach, selling your high-cost-basis lots while leaving lower-cost-basis shares in place. This article goes into greater detail on tax-loss selling. (If you're in the 0% tax bracket for long-term capital gains, you might also consider tax-gain harvesting; financial-planning expert Michael Kitces discussed the logistics in this video.) 

Don't: Disqualify your tax loss by forgetting about the wash-sale rule.
One of the drawbacks to tax-loss selling is that you might want to hang on to your laggard holdings, not throw them overboard, because they could rebound. Thus, here's another area where you want to be sure to put investment considerations ahead of tax factors in your decision-making. That said, it's worth noting that if you wait at least 31 days beyond your sale date, you can rebuy the same securities without disqualifying your tax loss. Alternatively, you can buy a different security that provides exposure to a similar market segment. If this is your plan, just make sure the security you're buying isn't "substantially identical." You can't, for example, sell an MSCI EAFE index fund and buy an ETF that tracks the same index, but you could switch from an actively managed fund to an index product. 

Do: Tie required minimum distributions in with portfolio maintenance.
You have until Dec. 31 to take your required minimum distributions from your Traditional IRA and 401(k) accounts, provided you're age 70 1/2 and older. Bear in mind that you don't have to take equal distributions from each of your holdings. Assuming you've calculated the correct amount of your RMDs for each account type, you can be surgical about where you go for the money. If your portfolio is heavier on U.S. large-cap equities than is ideal, for example, you can correct the imbalance by pulling your withdrawals from those holdings. That allows you to fulfill your tax-related obligations while also improving your portfolio's risk/reward profile for the future. This article provides some tips for RMD season. 

Don't: Spend any RMDs you don't need.
It's a high-class problem: Rather than take out living expenses from their IRAs throughout the year, some affluent retirees view RMDs as a necessary evil: Money has to come out of their IRAs to satisfy the IRS, but they don't really need it. If you're in that camp, remember that you can reinvest the money in a taxable account; just be sure to steer it toward tax-efficient investments such as stock index funds, exchange-traded funds, or municipal bonds. Alternatively, if you or your spouse has earned (that is, nonportfolio) income to cover your contribution, you can put the money into a Roth IRA. (This article discusses how to invest RMDs you don't need.) Of course, RMD time also coincides with gift-giving season; in 2014, you can give up to $14,000 to each individual without having to file a gift-tax return, and you can lower your tax bill via charitable contributions.

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Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.