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Mid-Year Tax-Cutting Tactics

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Amid all the turbulence in the markets, investors may be wondering how they can do something constructive with their portfolios. One way is to think about your tax planning and minimizing the taxes on your investments. Here with me to offer some tips on that and some opportunities that are out there today in the marketplace is Morningstar's Christine Benz. She is director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, nice to be here.

Stipp: So, first thing for you, the S&P 500 has been in the red for the year-to-date. We've seen a lot of up and down in the market so far. But there could be a silver lining here for investors on the tax front. Tell us a little bit about that.

Benz: Well, I am a big fan of tax-loss harvesting. So, looking through your portfolio, seeing if you have securities, stocks or funds that are selling below what you paid for them, if you sell them, you can use that loss to offset any capital gains. If you don't have any capital gains, you can use that loss to offset any ordinary income. So it's valuable on a couple of fronts.

And the other thing is, if you want that exposure in your portfolio, you can sell something and replace it with a similar security. So it's not like that you have to go without that type of exposure that you've just sold out of.

Stipp: "Similar' is sort of the keyword there because the IRS does have some rules about when you sell something and when you buy something in a period of time. It's the wash-sale rule basically. So what are the points to remember on that?

Benz: Well, it's not a clear line between what is a similar or dissimilar security. But generally speaking, if you sell some actively managed fund and buy another one, you'll be fine, or if you sell one company and buy another company in a similar sector, you'll be okay there, too.

What you don't want to get in the business of doing is taking one fund that tracks a certain index and replacing it with another fund that tracks the same index. That's a little bit of a sticky area. So, as long as it's similar but not identical, you should be okay.

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Stipp: Moving along to the fixed income markets for those who may be in higher tax brackets, there could potentially be some opportunity there. What did you see on what you might think advantages are for taxes?

Benz: Well, I think munis could be attractive. Municipal bonds could be attractive from a couple of different angles. Right now, on a pure yield basis, actually you can obtain a higher yield on some tax-free intermediate funds than you can on taxable Treasury funds. And that could owe in part to the fact that taxable Treasury funds' yields are really very low, near secular lows right now, but still that's a little bit of a yield pickup for people who are in higher tax brackets.

And then, also, when you look at it, if you think about tax rates potentially going up in the future, I think long term that could stoke demand for municipal securities, people seeking some relief from higher tax rates. So that's another possible tailwind for municipal bonds, even though there are obviously some risks hanging over the muni market right now as well.

Stipp: One of the big opportunities for 2010, and you've written a lot about this, both the pros and cons, is converting to a Roth IRA--and the folks it could be good for the folks and the folks who maybe should think twice about it.

But if you do think it's a good conversion, why it might right now be a good time to do it or to at least start thinking about it?

Benz: Well, a couple of reasons, Jason. One is that I think that as it becomes apparent that tax rates could go up in the future, you could see a stampede into Roths and into conversions toward the end of the year. So you don't want to wait until the very last minute and get caught in some kind of a paperwork tangle, so might as well start looking at whether conversion is a good opportunity for you.

And the other thing is that the taxes you pay on a Roth conversion might be lower right now when the market is at a low ebb and the investments earnings component of your IRA is at a low ebb, better to look at doing a conversion then when your tax hit will be lower than waiting for the market to go up. So, in this case, it's another silver lining of the recent market volatility.

Stipp: And you mentioned in your answer there the little bit of uncertainty about taxes and some folks think they may be going higher. There are some things on the horizon with the Bush tax cuts on the capital gains and the dividends potentially expiring and also some uncertainty on estate planning. How should investors think about those uncertainties that are out there in the tax market?

Benz: There is a lot of uncertainty out there, and it's really hard to plan for what you don't know. It does seem like there is some chatter about tax rates on dividends and long-term capital gains going back up to 20% from 15% currently for higher-income earners. So that seems like a realistic possibility.

And then, another thing is we hope we'll get some clarity on the estate tax. So, right now, the estate tax has been repealed for 2010. It's set to go back into effect in 2011. It does seem that a very likely scenario is that the estate tax will be reinstated, but estates under $3.5 million will be able to escape taxation. But it's all very uncertain. We really don't have any clear-cut answers on what's likely to happen with these tax situations.

Stipp: So, Christine, given that there is that potential uncertainty hanging out there, should investors make any movements in their portfolio? Should they think about selling out of dividend stocks or take any drastic action like that?

Benz: Well, probably not, Jason. I don't think it makes sense to get too fancy. And usually you would want to let investment merits drive any buy and sell decisions versus tax planning maneuvers, certainly ones where we're not sure about tax rates.

One thing I suppose you could consider is, if you do have a lot of capital gains in a security and you were planning to sell otherwise, consider selling this year versus waiting until next year. But probably you want to wait for a little more clarity on what's going to happen with tax rates before you do anything like that.

Stipp: Well, Christine, thanks for the tips and the insights.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.