It looks like 2004 will go down as a schizophrenic year for investors. Energy and telecom stocks are recording double-digit gains, but many technology and drug stocks are ailing. Just look at blue-chip losers such as Merck (MRK), down 33%, and Intel (INTC), down 35%. Maybe next year those losers will soar again, but for now you can use the rotten apples in your portfolio to trim your tax bill. The strategy is simple. Sell your losers to generate tax losses that can offset any gains you've taken or plan to take. If you have more losses than gains, you can apply up to $3,000 against other income -- anything more, you bank for another year. You may be reluctant to sell for a loss because you think the stock or mutual fund in question has strong prospects. But there are ways to, in effect, harvest your tax losses and keep the stock, too. The one caveat: To claim a loss for tax purposes, you can't buy back a security for at least 31 days.
For example, if you still really like Merck -- now reeling from the recall of its blockbuster painkiller, Vioxx -- but you are harboring losses, you could sell it and replace it with shares of another big drugmaker. But that could be risky if the new company gets into trouble, too. One option is to buy an exchange-traded fund (ETF) that specializes in pharmaceuticals, says Tobias Levkovich, chief U.S. equities strategist at Citigroup SmithBarney (C). A few good ETF candidates are iShares Dow Jones US Health Care (IYH) and Vanguard Health Care VIPERs -- both have large pharmaceutical holdings and hold Merck among their top five stocks.
Perhaps the best place to look for losses is in the tech sector. Particularly hard hit are semiconductor stocks such as PMC-Sierra (PMCS) (down 56%) and LSI Logic (LSI) (down 52%). One option is to sell those and replace them with an ETF such as iShares Goldman Sachs Semiconductor (IGW). Or you could replace them with such stocks as KLA-Tencor (KLAC) and Helix Technology (HELX), which build the equipment for manufacturing semiconductors, suggests Vadim Zlotnikov, chief investment strategist at Sanford C. Bernstein (AC). They'll be big beneficiaries of a rebound in capital spending.
Both Levkovich and Zlotnikov are cool toward tech stocks now, but if economic growth picks up next year, tech will be the place to be. So if you still like tech's prospects but don't have a strong preference for a particular stock or sector, replace your loser with an ETF such as the NASDAQ-100 Index Tracking Stock (QQQ), also known as Qubes, or the Technology Select Sector (XLK) SPDR, which owns all the tech stocks in the Standard & Poor's (MHP) 500-stock index.
What about Microsoft (MSFT)? It enjoyed a spurt last summer when it announced it is making a $3-a-share special dividend to shareholders of record on Nov. 17. But the stock has been flagging since and is flat for the year -- and will likely sell off on Nov. 18, when the stock starts trading without the dividend.
If you want to sell Microsoft and you've held the stock more than a year, it doesn't really matter if you sell before or after the special dividend's record date. Any gain would be taxed at 15% anyway, and any loss would be long-term. If you have a short-term gain of $3 or more, though, and will have owned it for 61 days, wait until after the dividend is paid. That way the $3 per-share payout is taxed at 15% rather than at a short-term capital-gains rate as high as 35%.
What if you have a loss on Microsoft? Just get out, says Robert Gordon, president of Twenty-First Securities. Here's why: Say you paid $29 for the stock within the past year and it's at $27. If you sell now, you have a $2-a-share short-term loss. If you wait until after the dividend is paid, the stock is likely to fall at least by the amount of the special dividend. That means your $27 stock drops to $24. You have to pay tax on that $3, and you have a $5 capital loss to boot.
Of course, now's the time to think about taking gains in addition to losses. You'll find profitable selling opportunities among the energy stocks. If you think oil prices have all but peaked, cash in and go elsewhere. If you think energy is in a long-term bull market, you can still sell to realize gains and immediately repurchase the stocks.
You may consider taking gains among the smaller, riskier drillers or refiners and moving the money into the giants such as ExxonMobil (XON) and ChevronTexaco (CVX). They're more defensive and more diversified, says Oppenheimer & Co. senior energy analyst Fadel Gheit. They also have ample dividends -- 2.2% and 3%, respectively.
Taking tax losses is not just about stocks. You can do it with your mutual funds, too. Large-company growth funds are down for the year, and that's one place to consider some selling.
Still, you don't want to be out of them entirely, since many analysts expect the bigger companies to outperform their small-cap peers in 2005 after a prolonged period of gains for small caps. So you may consider a swap, selling a large-cap fund and buying a similar one. If you're sitting on losses in the Vanguard 500 Index Fund (VFINX), a large-company blend fund, you may want to substitute it with the Vanguard Total Stock Market Index Fund (VTSMX). About 70% of the stocks in the two funds overlap. That's a favorite move of Gary Schatsky, a financial adviser at the ObjectiveAdvice Group in New York.
One warning: Before you trade in and out, make sure the new fund isn't about to make a capital-gains distribution, Schatsky says. Otherwise you might be welcomed into a new fund with a tax bill for capital gains that were earned long before you arrived. Check with the fund company directly if you plan to make any purchases before Dec. 31. Most companies will tell you when they plan to make a distribution -- and sometimes even how much.
In all likelihood, distributions will not be big this year. Plenty of funds are still carrying losses from the bear market, and they, like individuals, apply gains against losses to avoid making taxable distributions. Sometimes, it's even a good idea to buy funds with large tax losses; they'll shelter gains for a while. To find those funds, go to BusinessWeek's Mutual Fund Scoreboard (bwnt.businessweek.com/mutual_fund). Look in the last column, "Untaxed Gains," of the equity fund scoreboard. A negative figure indicates the fund has losses that may offset future gains, and the larger the number, the greater the losses on the books.
Keep in mind the cost of making your yearend tax trades. Factor in the brokerage commissions, for example, when you buy and sell an exchange-traded fund or option. Plenty of mutual funds now have 2% redemption fees if you sell within a set period, often 90 days or less. And it's best to avoid jumping into any funds with sales loads if you are only parking your cash there for a short time. The point is to avoid paying taxes -- not to rack up a lot of extra charges.
By Lauren Young and Suzanne Woolley