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Lay foundation to save on taxes

John Waggoner

Come April, you'll see dozens of articles telling you about the best tax tips. Here's your best tax tip: Don't wait until April.

By then, the only way to reduce your 2004 taxes is to open a deductible individual retirement account or claim your poodle as a dependent. Most people can't open a deductible IRA, and deducting Fifi will get you fined.

But you can make at least four smart tax moves now, and not one of them involves perjury. Just do them before Dec. 31, when the tax year ends.

Ditch your losers

The past five years have given investors plenty of opportunities to make mistakes, such as buying drug company Merck before it yanked its Vioxx painkiller last month or buying a technology fund in March 2000.

Taking a tax loss can ease some of that pain. You can use your losses to erase taxable gains. And if you have more losses than gains, you can take a deduction for up to $3,000 of your losses.

For example, suppose you bought 500 shares of Merck for $45.07 a share, or $22,535. You finally sold the shares on Nov. 3 at $27.87 for a $8,600 loss.

But you had also sold a stock earlier in the year for a $5,000 profit. You had owned the stock for more than 12 months, so your gain would have been taxed at the long-term capital gains rate of 15%. Your bill: $750.

You can use your loss to reduce your 2004 taxes two ways:

  • Use your $8,600 loss to erase your $5,000 gain. You'll now have $3,600 in capital losses remaining.
  • Provided you have no other gains, you can take your $3,000 deduction for your losses. If you're in the maximum 35% tax bracket, the loss will reduce your taxes by $1,050.

Your total 2004 tax reduction: $1,800. You can also carry the remaining $600 loss into the 2005 tax year.

But wait, you say: I'm a long-term investor. You should still take your loss. In the above example, you lost 38%. You'll have to gain 62% just to break even. If you really love the stock, you can buy it back after 31 days, although you'll need to wait that long because otherwise, the Internal Revenue Service will rule it a wash sale and disallow your loss.

But you can wait. The stock is unlikely to gain 62% in 31 days. Or, if you simply love the industry, you could buy another stock, such as Pfizer, right away.

Don't buy a distribution

Every year, usually in November or December, mutual funds must tally their gains from buying and selling stocks and distribute them to shareholders. They also must pay out the dividends they receive. (Chart: Estimated fund distributions for 25 biggest stock funds)

Funds don't pay taxes on those gains and dividends. You do. Even if you just bought the fund.

Suppose you buy a stock fund today. In December, the fund gives you $500 in long-term gains, $100 in short-term gains and $120 in dividends. If you're in the 35% tax bracket, you'd owe:

  • $75 on the long-term gains distribution, taxed at a maximum 15%.
  • $35 on your short-term gains distribution. Short-term gains are taxed at your regular income tax rate.
  • $18 on your dividends, which are taxed at capital gains rates.

Your total tax bill: $128. Had you bought after the distribution, however, you would have avoided the extra tax. If you're tempted to buy a fund in the next two months, make sure it has already paid out its distribution.

If you're buying the fund in a tax-sheltered retirement plan, such as an IRA, you don't have to worry about distributions. And thanks to the bear market, some funds, particularly aggressive growth funds, have lots of losses they can use to offset gains. (Funds can't distribute losses.)

If you want to avoid distributions entirely, look for a fund that also seeks to avoid distributions. These funds, called tax-managed funds, try to offset taxable gains with losses throughout the year.

Donate shares to charity

Let's say you want to donate money to Geese Unlimited, a charity devoted to preserving local waterfowl. You could just write a check and deduct your donation. But you can do better if you donate appreciated shares of stock instead.

Let's say you bought a gaggle of Google at $100 a share. It's now trading at $186. If you sold 100 shares, you'd get $18,600 and owe taxes on your $8,600 gain. Assuming those are short-term gains (Google went public in August), you'd owe $3,010 in taxes. But if you gave your shares to Geese Unlimited, you'd sidestep taxes on the gains entirely, and you'd get a deduction for the full value of your shares.

Sell winners in January

The longer you have the use of your money, the better off you are. If you sell a winning stock in December, you'll have to pay taxes on April 15.

But if you wait until January, you won't have to pay taxes on your gain until April 15, 2006. In the meantime, you could collect interest on that money — or reinvest it elsewhere.

But don't let tax considerations sway you from selling a stock. The most you can lose to the taxman on a long-term gain is 15% of your profit. The most you can lose to the market? Your entire investment. And that's one deduction you don't want.



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