Though most people find little humor in the subject of taxes, proper tax planning requires a sense of timing, just like a well-delivered joke. Though you should have your tax strategies in place throughout the year, there are several year-end moves you can make to hold on to your money.
Time your mutual fund trades.
If you’re looking to invest in a mutual fund during the fourth quarter, be careful. That’s because many funds pay out the year’s trading gains to shareholders in December. “You may be better off waiting until after the capital gains distribution,” says Ingrid John, a CPA and director of Capital Management Group in Washington, D.C.
If you don’t, you may be looking at a sizable tax bill if you’re investing outside of your 401(k). Suppose you invested in 1,000 shares of ABC Fund prior to the capital gains distribution. Assume you receive a $4 per-share distribution for a total of $4,000. John says that “unless you hold the shares in a retirement account like a 401(k) or an IRA, you’d owe tax on the $4,000 distribution” whether you take the cash or reinvest the distribution. Bottom line: You’d be taxed on the capital gains even though you didn’t own shares early enough to benefit from the appreciation.
In addition to dodging the tax hit, the fund’s shares will trade at a lower price after the distribution. So track the fund’s activity and buy shares after you see a distribution-related price drop.
On the flip side, it can pay to sell a fund for long-term capital gains before the distribution. Say you’ve been holding shares of an emerging markets fund for the past five years–during which time it has posted laudable returns–and because you believe those markets may cool down, you decide it’s time to sell. On a sale, most or all of your profits will be treated as long-term capital gains, probably taxed at a bargain rate of 15%. However, if you wait until after the distribution, you may receive an unpleasant surprise. Say the fund makes a $4 per-share distribution. In this hypothetical example, you discover that $2 per share (half of the payout) includes net short-term gains and dividends that do not qualify for the low tax rates enjoyed by most stock dividends. On that half of the distribution, you’d owe ordinary income tax, at federal tax rates as high as 35%. For sellers, sooner may be better than later.
Trim the Alternative Minimum Tax.
As its name suggests, the AMT is an alternative tax calculation. You (or more likely, a tax pro who understands this complex computation) must crunch the numbers both ways and pay whichever is higher, your regular tax or your AMT. “We contact our clients near the end of each year,” says John. “We run the numbers to see if they’ll owe the AMT. About two-thirds of them might owe this tax, so we see what they can do about it.” If your financial adviser is not so proactive, take the initiative and schedule a