How to turn a stock market loss into tax savings

Key Points

Q My broker sold many of my stock holdings last year at a substantial loss, which apparently saved me some taxes. Now that the market has improved, was this a good strategy?

A Last year's market selloff led many investors to take advantage of some unique tax planning opportunities. In a typical, relatively stable market environment, investment planning focuses on managing capital gains and balancing your portfolio among various asset classes. In a down market, investment planning is largely a matter of determining how you can make investment losses work to minimize your income tax liability and possibly even create tax savings. Regardless of the type of market we are in, it is important to use losses to offset gains, but the rules governing such strategies are not straightforward and have changed many times over the years.

Net short-term gains, on the other hand, are subject to ordinary income tax rates, causing many physicians to pay at the top tax rate of 35%.

Losses from a tax standpoint are not realized until you sell the investment for less than what you paid for it. So while it's discouraging to see an investment account statement showing "unrealized" losses, the loss does not benefit your tax situation if you still own it. If your net losses for the year exceed your net gains, you are allowed to only deduct up to $3,000 ($1,500 for married taxpayers filing separately) of the losses against ordinary income. You can, however, carry forward excess losses to future years.

By examining your unrealized gains and losses prior to the end of the year, you can time the sales of investments before year's end to achieve your tax planning goals. Based on last year's market drop, it could take a long time to fully absorb a substantial loss carryover, so you may want to realize gains before the end of the year, especially if it's an investment that you no longer want to own, in order to absorb previous excess losses. Keep in mind that end-of-year capital gain distributions from mutual funds can also be used to offset against capital losses.

If you are trying to achieve a tax loss with minimal change in your portfolio's asset class allocation, you should be aware of the "wash sale" rule. The "wash sale" rule prevents you from using a loss on a security if you buy the same or substantially identical security within 30 days before or after you sell the security that created the loss. If you don't pay attention to the details of the transaction you are making, the tax consequences of a sale may be different from what you intended.

As an example, the trade date, not the settlement date, of a publicly traded security determines the year in which you can recognize the gain or the loss. A proactive meeting with your accountant is highly recommended to ensure that you have time to maximize all of the tax planning opportunities available to you.

Q Is a "Letter of Final Instruction" a legally binding document?

A A Letter of Final Instruction, while very useful in providing an informal personal inventory, is not legally binding. Typically, the letter is addressed to a surviving spouse, adult children, lawyers, or to the executor, the legal term for the person responsible for the details in finalizing an estate. The goal is to ensure that those closest to you are aware of the existence of assets that otherwise might prove difficult or even impossible to find when death, a serious injury, or another crisis occurs. Additionally, instructions can be included pertaining to funeral arrangements or any other issues that may require direction, including the exact location of all important papers needed to settle the estate.

Be sure to list the names, addresses, and telephone numbers of people and organizations to notify in the event of your death. This list may include relatives, friends, clergy, attorneys, accountants, investment managers, insurance agents, financial institutions, and colleagues.

Joel M. Blau, CFP, Ronald J. Paprocki, JD, CFP, CHBCJoel M. Blau, CFP, (top) is president and Ronald J. Paprocki, JD, CFP, CHBC, is chief executive officer of MEDIQUS Asset Advisors, Inc. in Chicago. They can be reached at 800-883-8555 or blau@mediqus.com
or paprocki@mediqus.com
.

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