Win from Losing

Win from Losing

stockfigures3In the first quarter of 2008, the Dow Jones Industrial Average lost nearly 8%. That was the worst quarterly performance since 2002. What’s more, the Dow lost around 4% in the fourth quarter of 2007. The Dow remains a seesaw with wary inventors reacting to every bit of good and bad news that comes across their television screens. The bottom line, for many investors, is that they hold stocks and stock funds now selling for less than what they paid.

If you are in this situation, how should you react?
Limit your losses. Decide how far down a stock has to go before you sell it. For example, say you won’t take a loss that’s larger than 10%. If you buy a stock at $40 a share, you won’t hold it below $36: a $4 loss.

Take your losses. Some investors think they’ll hold on until they “break even.” That’s a mistake because a 10% drop can become a 20% or a 50% loss.

Don’t wait for year-end loss harvesting. Selling stocks and funds for capital losses is a common year-end tax planning tactic. However, if you wait until December, you may lose valuable tax breaks.

Why are losses valuable for tax purposes? There are several reasons:

  1. Capital losses can offset capital gains. You might owe tax this year from the sale of securities, the sale of real estate, the sale of a business, etc. Capital losses you take are netted against the gain, reducing the tax you owe.
  2. If you have taken losses, you can take gains without owing tax. Say you take $10,000 worth of losses in the spring of 2008. If the market turns around and you have gains in the second half of the year, you can take $10,000 worth of gains without owing tax.
  3. Net losses provide a tax deduction. Say you wind up this year taking $10,000 in capital gains and $25,000 in capital losses. You’ll owe no tax on the gains you’ve taken.
    “Each year, up to $3,000 worth of net capital losses can be deducted on your tax return,” says Tom Ochsenschlager, vice president of taxation at The American Institute of Certified Public Accountants. In this example, your $10,000 in gains and $25,000 in losses give you a $15,000 net capital loss. You can take a $3,000 loss on your 2008 tax return, saving you federal and state income taxes.
  4. Net losses you can’t deduct can be used in future years. In the above example, you have a $15,000 net capital loss for 2008. You deduct $3,000 on your 2008 tax return and “carry forward” the other $12,000, as your tax pro might say. Thus, you’ll be able to take capital gains in the future, knowing the first $3,000 will be tax-free over the next four years.

Don’t wait to reinvest. Once you’ve taken a capital loss, put the money back into the market. This time, you might have a winner, but if not, you can take another capital loss and