How Investors Are Lowering Their 2014 Tax Bills

"Don't let the tax tail wag the investment dog" goes an old expression, the idea being that one shouldn't be so concerned about taxes that one ends up making lousy investment decisions. Yet, tax planning is unavoidable for investors as it determines just how much of their gains and income they get to keep.

For many individual investors, the critical month is not April, when their income tax returns are due, but December, when their yearly investment performances finally come into focus and they have a better idea of how much they'll owe in taxes. It's also when stock mutual funds typically distribute their gains and income for the year to shareholders (and this year, investors in some popular funds will find these distributions to be quite large, as Morningstar director of personal finance Christine Benz points out here). For those who invest in individual stocks, it may be a time to engage in tax-loss harvesting--selling stocks that have lost value in order to offset gains from investments and other income.

We asked Morningstar.com readers on our Personal Finance discussion board what year-end tax strategies they plan to use this year, and they mentioned these and others. You can read the full discussion here. Excerpts are below.

Taking Advantage of 0%
Some readers said their year-end tax plans include taking advantage of the 0% long-term capital gains tax rate, which is available to single filers with taxable income of up to $36,900 and joint filers with taxable income of up to $73,800.

Bnorthrop said he or she will fall into the 0% capital gains bracket this year and plans to sell and rebuy some holdings in order to reset the cost basis on those purchases. His or her year-end tax plans also include using tax software to try to find a way to avoid having to pay the alternative minimum tax.  

Retiredgary also plans to avoid having to pay capital gains taxes.

"Since we are retired and not starting Social Security until next year and live in a state with no income tax, we are taking long-term capital gains in taxable accounts up to the income limit where they become taxable, realizing the gains with no tax at all," he said. "Since there is no wash rule for gains, people who want to can buy the things they sell back whenever they like at a higher basis for future calculations of gains." 

Doing Well by Doing Good
With the current bull market well into its sixth year, readers were focused on ways to avoid taxes on securities that have appreciated over that time. One popular method was by donating them to charity through donor-advised funds.

"I am gifting appreciated funds to my donor-advised account to avoid the large distributions, not paying taxes on the 100%-plus gain, and taking a tax deduction on the market value," wrote mjf143.

"I'll be gifting my open-end funds and tax lots that have appreciated the most into our donor-advised fund, thus avoiding all those capital gains," said javajoe. "Then we just take the cash we used to send directly to our favorite charities to Fidelity instead and use it to reset our cost basis."

Dumping Energy and Other Ideas
Other reader responses were more varied. For example, GregLee said that for his year-end tax strategy he is "deferring further investment in stocks until after mid-December, when my mutual funds pay dividends (which will be reinvested). Don't want to 'buy the dividend.'"

Dragonpat said, "I have already sold enough capital losses for my $3,000 quota against salary income for this year. Some of my energy holdings are in the dumpers, so I am going to start selling them off and carry over the loss to next year and start the 31-day wash rule waiting period to rebuy them at a lower [cost] basis. My company stock is at an all-time high right now, so I am gifting some of it to my children who are in lower tax brackets than myself. They sell it immediately and then use the proceeds to fund a 2014 Roth contribution. The Roth Christmas present."

In fact, the poor recent performance of energy stocks makes them an attractive target for some readers looking for holdings to sell at a loss.

"I will sell an energy fund for the tax loss," announced Nittwitt. "The amount of the loss seems to meet my tax deduction goal. I will reinvest some of the money from the sale into one or two specific energy companies that have gone on sale and seem to have what it takes to weather low oil pricing."

A few respondents mentioned that they will be retiring soon and outlined the tax moves they'll be making in preparation.

"We'll both be retiring in 2015, so 2014 represents the last year of a full-salaries/high-taxes situation for us, hopefully," wrote Grateful NW. "We're maximizing our 401(k) contributions, as usual, and avoiding any other actions that would increase the [tax] bite come April 15. I'm delaying cashing out any stock options from the company and planning to wait till 2016 to start converting IRA dollars to Roth accounts, which we don't have as of now."

Then, there was atomiccab, who commented that, for him or her, "there is little room for tax savings. I sold one short-term loss in November and December. I maxed out my 401(k) prior to retiring earlier this year. I have converted Traditional IRAs to Roth IRAs every year since 2010. What little is left in my solo 401(k) has been put in an IRA and will be converted next year. I have been replacing some dividend-paying stocks with muni-bond funds. This helps a little but does not help with the Affordable Care Act-related taxes and extra cost for Medicare."

Of course, it's important to remember that the point of investing is not to save as much as possible on taxes--it's to make money for yourself or for others, a point not lost on Edmund_Dantes.

"I am trying to maximize economic profit," he wrote. "This will naturally result in higher taxes in my non-deferred account. If I make more profit, I recognize that I will generate a bigger tax bill. That is the cost of doing business. I've considered the alternative: minimizing economic/trading profits in order to save on my tax bill. But that option was not especially attractive to me."

Some comments have been edited for clarity and brevity.