Now's the time of year when farmers harvest their crops -- and investors harvest their losses. That means checking your portfolio to see if there is anything you can sell to offset gains or reduce 2005 taxable income.
The basic strategy is to find losses and squeeze some tax benefit from them. Short-term losses are more valuable than long-term losses. Why? They can be used to offset short-term gains on which the tax rate can run as high as 35%, depending on your income. If your short-term losses exceed short-term gains, you can deduct up to $3,000 of losses from ordinary income. Anything more you can use in future years.
As you review your portfolio, there will be some stocks you're reluctant to sell. Dell (DELL ), for instance, is down 21.3% so far this year, but you still may think it's attractive. That's when the tax harvesting gets tricky. You can sell Dell for the loss and buy it back 31 days later. But purchase any shares sooner, and you'll trigger the "wash-sale rule," which will nullify your tax deduction.
You can realize your losses toward yearend without totally giving up your favored stocks. One way is to double up -- purchase Dell shares equivalent to the number you want to unload -- and sell the older, higher priced shares after 31 days. You take a loss on the older shares, but establish a new position at a lower price. This is what portfolio manager Don Peters of the T. Rowe Price Tax-Efficient Growth Fund is considering with Wal-Mart Stores (WMT ) and Avon Products (AVP ). "I don't expect them to do much in the short-term," he says. "But they are so attractively valued that long-term investors should consider doubling up or doing something to maintain their exposure."
BUY A COMPETITOR
Another tactic is to swap your losers for similar securities. You could sell Wal-Mart and buy a mutual fund or exchange-traded fund that is heavily invested in Wal-Mart such as the Rydex Retailing Fund (RYRCX ), which has a 6.9% Wal-Mart position or Retail HOLDRs, which has 17.5%. The risk is the fund may not move dollar for dollar with Wal-Mart.
Or you could buy a competitor's stock. "Target (TGT ) probably is the best substitute for Wal-Mart," says T. Rowe's Peters. But Target's customers come from a higher-income group, so the stocks might not track exactly. Peters suggests replacing Wal-Mart with a combination of Target (TGT ) and Dollar General Stores (DG ), which serves a lower-income customer.
You can also harvest losses, double up, or swap losing mutual funds. Just be careful not to buy a new fund right before it's about to make a capital-gains distribution at yearend. (Call the fund company or check the Web site for the distribution date.) In fact, swapping funds is easier than stocks because while no two stocks are exactly alike, fund portfolios often overlap. Although, for instance, you cannot replace one Standard & Poor's 500-stock index fund for another without violating the wash-sale rule, you could sell your S&P 500 fund and buy an iShares Russell 1000 exchange-traded fund (IWB ), which has more than half of its portfolio invested in the same stocks.
Perhaps the best tax-harvesting opportunities are in bonds. Because the same companies offer multiple issues, you can essentially swap one bond from a company for another with a different maturity and coupon payout, says money manager Ivan Gefen, who oversees $250 million in taxable accounts at vFinance. "When the credit ratings of GM (GM ) and Ford (F ) bonds got downgraded this year, they took a nosedive," he says. "Those companies have hundreds of issues you can swap."
While it's good to harvest tax losses now, many pros do it whenever the opportunity arises. "The tax clock is ticking very loudly this time of year," says Duncan Richardson, manager of the $18 billion Eaton Vance Tax-Managed Growth Fund. That's why the market often falls in October and November, and bargains abound. Put it on your to-do list for 2006: Harvest your losses early and often.
By Lewis Braham