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Capital losses can help cut your tax bill

'Kiddie tax' complications

In an effort to catch rich parents who were trying to circumvent investment taxes by putting assets in the names of their children, the "kiddie tax" was enacted in 1986. Don't be confused by the name. Under this law, a kiddie portion of taxes usually is quite large.

Basically, the law requires a child's investment earnings over a certain amount ($1,800 in 2008; $1,900 in 2009) to be taxed at the parent's higher tax rate until the child reaches a specific age, when the youth's lower rates apply. For many years, that age was 14. But in recent years, Congress has been upping the age target.

For 2008 tax purposes, a child's investment income is taxed at the parents' higher rate (typically 15 percent on long-term capital gains and dividends; up to 35 percent on short-term gains and ordinary income), until the young man or woman turns 19, or 24 if the child is a full-time student.

If parents find themselves liable for more investment income than they had planned because they had to cover the taxes on their children's asset earnings, one of the easiest ways for that parent to reduce or eliminate the unexpected gains is to take tax advantage of assets that produced offsetting losses.

Timing is everything

While many factors will affect your choice to sell a security, tax considerations can be a major component of such a decision.
  • Capital losses are best taken in a year with short-term capital gains or no gains, because you will save on your full ordinary income tax rate. The tax consequences of a short-term capital gain can send you looking for a devalued stock to purge from your portfolio. Dump the losers; enjoy the tax break.
  • Long-term capital gains have an attractive low tax rate (15 percent for most investors), so the benefit of a deductible loss is much less.

Tax rate considerations

Also keep in mind that your tax rate matters when it comes to losses. If you are in the 10 percent or 15 percent brackets, you won't owe any capital gains taxes on assets sold for a profit in 2008.

Individuals who might benefit from this zero capital gains rate include retirees, or folks who've reduced their work schedule as they near retirement and young workers whose first full-time job doesn't pay much. These individuals who have investment earnings and sold them in 2008 (or sell in 2009 and 2010, too) don't have to worry about offsetting gains by selling assets that will produce a loss.

Of course, you shouldn't make investment moves based solely on tax considerations. But you definitely should take every available tax advantage that those moves offer.

Wash away those losers?

But what if the only deflated stocks in your portfolio have a lot of promise to rebound to profitable glory? You might think of selling something off to create a loss, and then repurchasing the stock so you can ride it back up.

Not so fast, bucko. The IRS is a step ahead. The tax folks closed up that loophole with something called the wash sale rule. The catch is you can't claim a loss from the sale of a security and then turn around and buy a substantially identical replacement within 30 days.

For example, if you sell a stock and then pick it up again a week later after it splits, the IRS knows it's still the same stock. So if you want the tax break, you have to take a risk and wait 31 days to pick up that stock or security again.

For a more subtle way to work within the wash sale rule, you could sell shares of one company's mutual fund and pick up the same type of fund from another company. For example, sell off the Vanguard Health Care mutual fund and then buy into Fidelity's Heath Care mutual fund. For bonds, be sure to buy a new one that differs from the old one in one or, even better, two of the following criteria: issuer, credit rating, maturity and yield.

Though capital losses can lessen the pain from a gain, they are not the way to wealth. Your ideal financial scenario would be for every stock to be a long-term winner. But for that you need a crystal ball, not a tax form.

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