Six reasons to book tax losses and move on.
By Christine Benz | 12-04-08 | 06:00 AM | Email Article

One of my recent mutual fund statements was accompanied by a handy article on year-end tax-saving maneuvers. It included helpful hints such as how much you can contribute to an IRA and pointed out the risks of buying a fund before it makes a capital gains distribution.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

However, it failed to mention the Big Kahuna of tax-saving maneuvers this year: tax-loss selling. Most fund companies have already seen a fair number of spooked investors flee this year, so you can see why they might be inclined to withhold a legitimate reason to sell.

Everything's way down this year, and the best way to get a little something out of all the grief you've endured is to book losses on the securities that are currently selling at prices below what you've paid for them. I wrote about tax-loss selling back in August, when the market environment was scary but not yet horrific. But if you didn't heed my advice back then, you're still in luck. Stock market losses have only deepened since that time, making it all the more likely that you've got losers you can monetize. If you sell depressed securities from your taxable accounts before Dec. 31, and your losses outweigh capital gains elsewhere in your portfolio, you can use those losses to offset ordinary income on your tax return. (The rules are different if you're selling securities from your IRA; I'll discuss that topic in depth in next week's column.)

Tax-loss selling can be psychologically difficult. After all, it entails turning paper losses into real losses, and that doesn't feel good. So if you need more convincing that you should carve time out of your holiday schedule for tax-loss selling, here are some additional benefits.

1) It's the first step in the rebalancing process.
Rebalancing--getting your stock/bond allocations back in line with your targets--is arguably more important this year than ever before. Even if you haven't sold a share of stock or stock funds, it's likely your equity weighting is now far lower than what you intended it to be, and you'll need to take steps to get it back there. (I'll write more about the how-to of rebalancing in a future column; here's an earlier article on this topic.) Tax-loss selling should be your first step in the rebalancing process. By the time you've pruned your losers, most of which are apt to be stocks and stock funds, you'll be able to get a true read on how much equity exposure you need to add.

2) You can upgrade the quality of your portfolio.
Rather than viewing tax-loss selling as a sign of failure, think of it as a do-over with a tax benefit. In addition to booking losses, you also have the opportunity to build the best possible portfolio by swapping in stocks and funds with great fundamentals. Nearly every great mutual fund, ranging from the legendary  Sequoia Fund  to some long-closed Wasatch funds, is now open for business, and most of these managers tell us they're finding an unprecedented number of cheap stocks right now. (Our  Fund Analyst Picks list highlights the offerings we view as best of breed in every category.) And with many stocks priced for Armageddon, our stock analysts are also finding an awful lot to like right now. To screen for high-quality companies with sustainable competitive advantages, I like to use the  Premium Screener to home in on 5-star stocks with wide moats. More than 100 stocks currently clear that hurdle, ranging from  Johnson & Johnson  to  Microsoft .

3) You can get rid of your mistakes.
Woulda, shoulda, coulda. Woulda bought a bear fund instead of a leveraged S&P fund. Shoulda anticipated the drop in oil prices and dumped my energy stocks. Coulda gotten out of  Google  while the getting was good. We all have regrets about our portfolios from time to time, things we wish we'd done differently. The fact that the clock is ticking on the current tax-loss season provides you with an ideal opportunity to look those mistakes in the face and move on. And by the way, if you do identify true mistakes in your portfolio--most often, speculative stocks and funds that you purchased without doing your homework--resolve to avoid those traps in the future.

4) You can set up a system for cost-basis tracking.
Central to tax-loss selling is that you have some sort of a system for tracking your purchase prices. With a precise system for tracking your basis, you can get a much better read on which securities you're holding at a loss, and you can also pursue more refined strategies such as the "specific share identification method." (For more details on tracking basis, check out this article.) If you don't have a system for tracking your cost basis, it's time to get one. You can set up a spreadsheet detailing the dates and purchase prices of each of the securities in your portfolio, and fund companies and brokerage firms have also developed increasingly sophisticated tools for helping clients track their cost bases.

5) You can avoid impending capital gains distributions.
Talk about adding insult to injury. Even though the typical stock fund has lost more than 40% of its value so far this year, many mutual funds are planning to distribute capital gains to their shareholders over the next month. By and large, that's because they've had redemptions, and to pay off departing shareholders, they've had to sell long-held securities and realize capital gains. Normally I'd say not to get too fancy about trying to dodge impending capital gains distributions, but given that many of your holdings are probably under water, these are not normal times. If you were planning to sell a fund anyway, you're better off doing so before it makes a distribution. Check your fund companies' Web sites to see if your funds are planning to make distributions over the next month, and consider selling preemptively before they do. Just be sure that the funds you're buying instead aren't about to make distributions themselves.

6) You can find a silver lining.
Last but not least, the key reason to consider tax-loss selling is that you can end a horrible year in the market on a semi-good note. By cleaning out your losers, upgrading the quality of your portfolio, and receiving a bit of a tax benefit, you can go into 2009 knowing that your portfolio is in fighting shape for whatever lies ahead.


Introducing the new Morningstar PracticalFinance!
Our new editor, Christine Benz, brings a fresh perspective to Morningstar PracticalFinance. You may have seen Christine share her expertise on CNBC, Fox Business News, or the Nightly Business Report.In each issue of PracticalFinance, she leverages Morningstar's many resources to deliver sound strategies that can help optimize your investments and reach your goals.
Learn more.
 $95.00 for 12 Print Issues $79.00 for 12 PDF Issues 
Securities mentioned in this article



Morningstar Rating Morningstar Analyst Report
With Morningstar Analyst reports you can get our expert Buy/Sell opinions on over 3,900 Stock and Funds
Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
Sponsored Links
Sponsor Center
Content Partners