Dealing With Portfolio Losses

If you have investments with substantial losses, consider these strategies to improve your results:

1. Use stock losses to offset other capital gains. You may use stock losses to offset other types of capital gains. You don’t have to match stock losses with stock gains. If you have capital gains from the sale of another type of asset, such as a business or real estate, consider selling stocks with losses to offset those gains.

2. Recognize losses to at least offset $3,000 of ordinary income. Keep in mind the tax rules regarding capital gains and losses — capital losses offset capital gains and an excess of $3,000 of capital losses may be offset against ordinary income. If you are holding stocks with losses in your portfolio, consider the advantage of this tax rule.

Can’t bear to part with any of your stocks right now? You can sell the stock, recognize the tax loss, and then repurchase the stock. You just have to make sure to avoid the wash sale rules. These rules state that you must repurchase the shares at least 31 days before or after you sell your original shares to recognize the loss for tax purposes. That timing can be troublesome. If the stock’s price rises substantially before you repurchase it, your tax savings from the loss deduction may not be worth as much as the investment gains during that time period. You can avoid that concern by purchasing the additional shares first and then selling your original shares 31 days later. Another strategy is to purchase a similar stock, perhaps a competitor, to replace the stock you sold. Since it isn’t the same stock, you don’t have to wait 31 days to purchase it.

3. Consider recognizing all, or a substantial portion, of your losses. First, realize that no one likes to sell investments at a loss. And since you may only offset an excess of $3,000 of capital losses against ordinary income, you might wonder why you should incur large losses that can’t be used currently, even though you can carry them forward to future years. There are a couple of advantages to this strategy.

First, it gives you an opportunity to totally reevaluate your portfolio. If you are convinced all your investments are good ones, you can sell them, recognize the tax loss, and then repurchase the stocks, being sure to avoid the wash sale rules. But it’s probably more likely that you own some investments you wish you didn’t or you don’t think will recover as quickly as other investments. This is your opportunity to reinvest in stocks you believe have better potential going forward.

Second, it gives you more flexibility when recognizing gains in the future. You may be a little more skittish than you were during the bull market a few years ago and may be uncomfortable letting capital gains ride with the market. Until you use all your capital losses, you can recognize capital gains without worrying about paying taxes. Even if your losses are long term, you can use them to offset short-term capital gains that would be subject to ordinary income tax rates.

4. Convert a traditional individual retirement account (IRA) to a Roth IRA. When converting from a traditional to a Roth IRA, transferred amounts must be included in income if taxable when withdrawn (for example, contributions and earnings in traditional IRAs and earnings in nondeductible IRAs), but are exempt from the 10 percent federal income tax penalty. Converting at a time when portfolio values are down, will generally result in a lower tax bill. Once the IRA is converted to a Roth IRA, qualified distributions may be taken on a tax-free basis. Conversions are now available regardless of your income level. There are many factors to consider, but the ability to pay the tax bill with funds outside the IRA is a major advantage.

5. Don’t gift stocks with losses. If you are planning a large charitable contribution, it makes sense to donate appreciated stock held for over a year. You deduct the fair market value as a charitable contribution, subject to limitations based on a percentage of your AGI, and avoid paying capital gains taxes on the gain. If the stock has a loss, however, you should sell it first and then send the cash to the charity. That way, you get the charitable contribution and recognize a tax loss on the sale.

No one is happy when faced with substantial stock losses. At this point, however, the only thing you can do is use those losses to your best advantage.

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