Posted on: Sunday, December 7, 2003

Tax breaks, 3-year market slide provide flexibility

By Hope Yen
Associated Press

NEW YORK — With 2003 winding down and the stock market higher, mutual fund investors might be hesitant to adjust their portfolios for fear of adding to their tax liability come April. In fact, investors now have unique opportunities to minimize their taxes.

December is typically the time the stock market has a holiday rally, prompted partly by an absence of sellers as investors refrain from unloading high-performing stocks that incur capital gains taxes.

Investors don't need to worry about tax-deferred accounts such as 401(k) retirement plans or individual retirement accounts, which aren't taxed until investors withdraw the money.

But for taxable accounts, advisers say this year's reduction in dividend and long-term capital gains taxes, as well as the past three years of market declines, give investors flexibility to make changes. Here are some of their suggestions:

• Harvest capital losses. Tax-loss harvesting allows investors who sell mutual funds at a loss to offset realized capital gains or ordinary income up to $3,000. In addition, capital losses of more than $3,000 in previous years may be carried over to offset gains in future years.

So although most stocks are higher this year, investors won't likely incur tax liability if they carry over their losses from the previous years. That means investors can more freely cash out of well-performing mutual funds if they feel they're overweighted in a certain area.

It also can liberate jittery investors who might be unduly clinging to a mutual fund under investigation for improper trading because of worries about tax consequences. And it might make sense if investors are betting that market performance in 2004 will only be modestly better, if not weaker.

"Investors sometimes forget they can occasionally use (tax-loss harvesting) in a profitable and sensible way by taking some gains," said Don Cassidy, senior research analyst at Lipper Inc. "It's an asset sitting there you could use in a creative way, so why not use it to free up money and change up a portfolio without worrying about gains you might want to take?"

• Consider putting stock funds in taxable accounts and fixed-income assets in tax-sheltered 401(k) plans and IRAs.

This year's tax cut reduces the rate on dividends and long-term capital gains to 15 percent until 2008. Previously, capital gains on investments held for more than one year were taxed at 20 percent, while dividends were taxed as ordinary income at federal tax rates as high as 38.6 percent.

Thus, many investors previously chose to put stocks in 401(k)s and IRAs to defer the tax liability. However, since capital gains earned in the tax-sheltered accounts are ultimately taxed as ordinary income, investors who now follow this strategy would pay a higher rate than if they kept stocks in a taxable account, where capital gains and dividends are taxed at 15 percent.

Meanwhile, since dividends earned from interest on cash and bonds don't qualify for the new tax cut, it would make sense to keep such fixed-income assets in the tax-sheltered accounts, advisers say.

"What we would recommend is for clients to look at their portfolios overall, determine what their asset allocation mix is appropriate overall and then look at where you want to hold these particular investments," said Marion Gilman, a certified financial planner in Peabody, Mass.

"It's certainly more advantageous to hold interest-bearing investments in a tax-deferred account rather than outside a 401(k) at this point in time," she said.

• For taxable accounts, avoid buying a mutual fund before the capital gains distribution.

Fund companies typically distribute their accumulated capital gains from October until the end of the year. If investors buy into a fund before the distribution, they could be taxed on gains they didn't benefit from earlier in the year and then end up with a fund that's worth less after the distribution payout.

Investors can call or check a fund company's Web site to find out the distribution date.

• Don't forget the basics of investment goals and portfolio allocation.

Advisers stress that investors shouldn't seek to unduly minimize tax liability at the expense of returns. If a 401(k) has poor bond funds but good stock offerings, for example, don't pick an underperformer for the sake of lowering taxes.

Similarly, people in their 20s or 30s with a longer time horizon and greater appetite for risk might want a heavier weighting in stocks with less of a need for bond allocations in either 401(k)s or taxable accounts, they say.

"I'm a big believer of allocating and rebalancing and not trying to time the market," said William B. Howard Jr., a certified financial planner in Memphis, Tenn. "People should have an overall investment game plan and a portfolio allocation."