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TAMING THE TAX MANEase the sting of this year's market correction with smart tax movesIf there's a silver lining to this year's market turmoil, maybe it's this: 1998 is going to be one heck of a year for tax planning. O.K., so maybe the vision of quality time with your accountant doesn't make your heart sing. But with the right tax moves, you can let the Internal Revenue Service share the pain of tumbling markets. Meanwhile, your portfolio's roller-coaster ride has created ample opportunities to make tax-savvy gifts to your heirs and tune up your retirement accounts. But it's best to act now--not when your tax preparer calls in mid-December to schedule a yearend checkup. Start with your retirement accounts. If you hurried to convert a traditional individual retirement account to a new Roth IRA during 1998's first half, you probably made a good choice but at a bad time. To make that conversion, you must pay taxes on the old IRA's value, less any nondeductible contributions. But if you converted a $100,000 IRA before the market's tumble, you now face taxes on $100,000, while the account's value may have fallen to $75,000 or less. Fortunately, Congress gave you an escape hatch. You can undo the traditional IRA-to-Roth conversion, then reconvert to a new Roth IRA at the account's new and diminished value. If the reconverted IRA is worth only $75,000, you only face taxes on $75,000--and can, if the transaction is wrapped up in 1998, spread the tax load evenly over four years. On Oct. 20, the IRS announced that savers would be allowed to undo a Roth conversion and then redo it only once per account between Nov. 1 and the end of 1999. After that, the tax agency hinted, such round trips might be banned. If you're like most investors, the bigger concern is the state of your taxable accounts. The four-year bull market and three-months-and-counting correction have left most investors with a mix of long-term gains and short-term losses. Take someone who plugged $1,000 a month into stocks matching the Standard & Poor's 500-stock index starting in January, 1994, reinvesting aftertax dividends. By Oct. 1, Ibbotson Associates calculates, that person would have been sitting on $35,055 in potential long-term capital gains on stocks held for more than 12 months, plus $349 in potential short-term profits and $495 in potential short-term losses. Those gains and losses are unrealized, and have no tax effects until a sale. But what if you cashed out some positions during the sell-off? You're now staring at some sizable realized capital gains. ''Take some losses now to offset those gains,'' advises Thomas P. Ochsenschlager, a partner at accountants Grant Thornton. WILD CARD. Be sure to take enough short-term losses to wipe out any realized short-term gains, which would be taxed at your top federal rate, up to 39.6%. You can also use net short-term losses to cover long-term profits dollar for dollar. But that's less rewarding, since net long-term gains are taxed at 20% or less. If your realized losses already exceed your capital gains, you can use the excess to shelter up to $3,000 ($1,500 for married taxpayers filing separate returns) in salary, interest, or dividends. (Congress eliminated 1997's awkward medium-term category, for assets held 12 to 18 months, in this year's IRS reform bill.) The wild card in these calculations may be your mutual funds. During the summer slump, many funds sold stocks and realized short- and long-term gains that must be distributed to shareholders by yearend. It's not bad enough that your fund may be down 20% off its peak. You're going to face a tax bill as well. What can you do? First, call your fund to get an estimate of the distribution's size and its record date. If you own shares on that day, you'll be credited with the dividends and long- and short-term capital gains the fund distributes. Some fund families, like Vanguard Group, have already published figures. Fidelity Investments, the largest fund group, expects to post estimates in late November. Your fund company can also help figure your basis--usually the average cost you paid for shares bought directly and via dividend reinvestment. Then consider whether this fund belongs in your portfolio for the long term. If not, sell it before the record date, and don't buy a replacement until the new fund has distributed its gains. If it's a fund you want to keep, compare its current value to your basis. If it's worth less than you paid, you might want to sell now to claim the loss and avoid the distribution. If you've profited, as you probably have on most funds you've owned more than a year, the tax on your gain if you sell probably exceeds the tax on the distribution. Swallow hard and look for losses elsewhere to offset the distribution. ''DOUBLING UP.'' What if you've lost money on funds or stocks that you nevertheless think have a future? You can sell to claim a loss, then buy them back. But be careful. Under the IRS' ''wash sale'' rule, the loss will be disallowed if you buy the same or substantially identical securities within 30 days before or after the sale. Note that options on the stock you're selling, or the same issuer's bonds with the same interest rate, would be deemed ''substantially identical,'' according to tax experts at the J.K. Lasser Institute. To avoid being out of the market for a month, you can buy similar securities--a different growth fund, say, or Exxon instead of Shell. Or you can ''double up'' by purchasing another block of the same security before Nov. 30, then selling the original, loss-ridden block 31 days later. That assumes you always instruct your broker or fund to sell specific shares, the best practice if you want to minimize taxes. You don't have to sell weak stocks to get tax advantages from them. When share prices are down, gifts of stock to your children or grandchildren can pay off. Say your stock falls from $50 to $40. Your $10,000 gift, the amount you can give one recipient annually without triggering gift tax, will now cover 250 shares, rather than 200. Your recipient's portfolio will be larger and your eventual estate tax bill smaller. Stock options can put an extra spin on the strategy. Say your employer awarded you nonqualified options, the most common type. They are now vested but under water. In other words, the stock is selling for less than what you would pay to exercise your option. As a result, the option's value may be a fraction of the shares' actual price. Planner William Baldwin of Pillar Financial Advisors in Lexington, Mass., cites a client with 12,975 options, exercisable at $15 a share, in a biotech stock selling for $5.13. Under the IRS's valuation, the options were worth $1.42. But the client had a longer view than the tax man. ''He believes these shares are going to go to $50 or higher,'' Baldwin says. So Baldwin advised the client to give the options to his grandchildren in trust. If the stock recovers and the trustee exercises the options and sells the shares, the client will then have to pay tax, at ordinary-income rates, on the difference between the stock's market value and the exercise price. But by then, ''his other shares [in the company] will be up, he'll be feeling flush, and he'll have avoided a lot of estate tax,'' Baldwin says. This strategy won't work for incentive stock options because they aren't transferable. Once you know where your investments stand, you need to rough out your total tax picture for 1998. Pay special attention to the alternative minimum tax, a special levy that bites when your deductions and other tax breaks exceed IRS limits. Lots of net short-term gains, or heavy state and local tax payments, can throw you into the AMT. If so, you'll want to stand the traditional yearend tax-planning advice on its head: Postpone deductible expenses, which the AMT devalues, and speed up income, which the AMT taxes at 28% instead of rates up to 39.6%. Tax planning is no one's idea of fun. But then, neither is a bear market--let alone a bear market followed by a big check to Uncle Sam. Tune up your portfolio now, and you'll at least have the pleasure of sharing the bear with the IRS.
By Mike McNamee in Washington RELATED ITEMS
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Updated Oct. 29, 1998 by bwwebmaster
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