NEW YORK (TheStreet) -- All of a sudden its December -- time to harvest those tax losses.
If that observation has you scratching your head, heres a quick primer.
Federal capital gains taxes are charged for profits made in taxable accounts, which include most investments that are not in tax-deferred accounts such as traditional IRAs and 401(k)s.
Tax bills are triggered when you sell an investment at a profit. If you bought a share of stock for $100 and sold it for $200, the $100 in profit would be taxed in the year the stock was sold. If the stock had been owned for longer than one year, the maximum long-term capital gains tax rate is 15% (or 20% for people with large incomes). If the stock had been held for a year or less, the gain would be taxed at the short-term rate, which is the same is your income tax rate, anywhere up to 39.6%.
Of course, most investors at one time or another have investment losses as well. So when you do your tax return the losses are subtracted from the gains to come up with a net gain or loss. Losses, then, can reduce or eliminate your taxes on gains. And if losses exceed gains, they can be used to reduce your taxable income by up to $3,000 a year, or they can be carried forward to be applied against capital gains or income in future years.
Thats why investors are urged to hunt around for money-losing investments to sell before the tax year ends Dec. 31.
It sounds simple, but not all losers are created equal. Some, of course, have bigger losses than others, making them more valuable at tax time. That would seem to make them better candidates for year-end selling, but theres a catch: What if the investment were to rebound? By selling, you could miss out on gains that might in the long run be more valuable than the tax loss.
Perhaps you could sell the holding and buy it back? Well, the IRS is on to that gambit. A regulation called the wash-sale rule prohibits taking the loss if the same security, or one much like it, is bought within 30 days of the sale. You could, of course, buy the security back after the 30 days have lapsed, thereby preserving the tax loss from the sale, but youd miss any rebound that came during those 30 days.
So those are all the basics of tax-loss sales. The tricky part is deciding whether your loser is more valuable as a tax loss or as a potential winner in the future. Savvy investors try to put the past behind them, focusing on how they think the holding will do in the future regardless of what it has done in the past.
With each holding, ask yourself: If I had some cash, would I buy it today? If the answer is yes, keep the investment. If the answer is no, sell it.
That same question, by the way, should be asked of the profitable investments as well, because this years winner could be next years loser. Investors should focus on the future, not the past.
Investing experts often warn clients not to let the tax tail wag the investing dog. In other words, dont let tax issues drive your investment decisions. A promising investment should be kept even if that means passing up a tax loss.
But this late in the year, as opposed to March or June, its not unreasonable to let tax issues influence your timing. Assuming you dont expect any significant price changes before the end of the year, you could wait until January to sell profitable investments, so the tax will be owed in 2014 instead of 2013.
Losers you want to sell should be sold this year, so you get the tax benefit now rather than later.