Tax Planning for Investments

Taxes are a vital part of any investment decision. But always remember that taxes are only a part of an overall investment strategy. Financial advisers recommend that you make investment choices not solely on tax avoidance - but on what you can expect to earn, the level of risk you're willing to take, and the diversification of your portfolio.

CAPITAL GAINS
A capital asset is any property you can buy or sell. That includes securities, your home and other real estate, jewelry, cars, and collectibles. A capital gain is your profit when you sell an asset for more than it cost you. You have a capital loss, on the other hand, if you sell the asset for less than it cost.

Capital gains are usually taxable. Capital losses are deductible only if you've held the item for investment and not for personal use. So you also need complete records for all of your transactions and expenses. See IRS Publication 550, "Investment Income and Expenses," for the details. You can download or view a copy at the IRS website, www.irs.gov.

FIGURING GAIN
You figure gain or loss by subtracting your basis from the proceeds of a sale. Basis is the price paid for the item, plus the expense of buying, holding and selling it. For example, the commissions and costs of an investment transaction are subtracted from the proceeds of a sale when you figure a gain or loss. If you received the item as a gift, your basis is the same as the giver's was. If you inherit an asset, your basis is the market value on the date of the giver's death. See IRS Publication 551, "Basis of Assets."

figuring gain

Here's how you would figure a capital gain:

LONG- AND SHORT-TERM GAINS
tax shelter

If you hold an asset for 12 months or less, any increase or appreciation in its value will result in a short-term gain. These gains are taxed as ordinary income, at your regular tax rate. But if you own an asset for more than a year before you sell at a profit, you have a long-term capital gain. Those gains are taxed at a maximum rate of 15% if your regular tax rate is 25% or higher. And if your regular tax rate is 10% or 15%, long-term capital gains are taxed at 5%.

THE LONG AND THE SHORT OF IT

DEDUCTING CAPITAL LOSSES
If you lose money on an investment, you may be able to deduct your losses. You can combine your capital gains and capital losses - short-term gains with short-term losses and long-term gains with long-term losses - to offset, or reduce, the gains on which you owe tax. Or you may wipe out all your gains and have a net loss.

If you have a net loss, you may use it to reduce your taxable income, but there's a cap of $3,000 per year ($1,500 if you're married and filing separate returns). If your loss is greater than that amount, you can carry over the excess and deduct it in later years.

Specific rules apply to figuring losses on investments you receive as gifts. You may want to consult your tax adviser to be sure you handle reporting them correctly.

HOLDING STOCK DEFERS CAPITAL GAINS TAXES
While you're holding an investment, you don't pay tax on any increase in value. The market price of a stock you bought for $5 a share may climb to $50, but the tax on that capital gain is deferred until you sell the stock and collect the proceeds. If you sell when you've held stock for more than a year, you owe tax at the capital gains rate, which is always lower than your ordinary income tax rate. Qualified dividend income, from most stocks and equity mutual funds, is also taxed at your long-term capital gains rate.

THE GAIN OF GIVING
If you donate appreciated property, such as stock or a house, that you've held for over a year, you may be able to deduct the market value and avoid capital gains tax on the appreciation. If a stock's value has dropped, you can sell it, take the capital loss and donate the proceeds of the sale.

Once your child is over age 14, you can often save on taxes by giving the child stock that has appreciated in value while you owned it. The child sells the shares and pays capital gains tax at a lower rate than yours.

PASSIVE INCOME
Passive income or losses come from businesses in which you aren't an active participant. These include limited partnerships, rental real estate, and other business ventures that you don't help manage.

Losses from passive investments may be used to offset only income from similar ventures. The losses cannot shelter other income. That is, they can't be used to offset active income, such as wages and salaries, or portfolio income, such as interest, dividends, and capital gains. Losses you can't use in the year they occur may be deducted only when the passive investment is sold or disposed of in a taxable transaction. A gift is not a taxable transaction.

TAX-DEFERRED INVESTMENTS
You may be able to take advantage of a variety of tax-deferred investments that allow you to accumulate earnings on which you owe no tax until you begin withdrawing money, usually after you retire. Many companies sponsor tax-deferred retirement plans, such as 401(k)s , for their employees. Or you may open an IRA or other individual plan.

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There are usually contribution limits on the amount you can invest each year in tax-deferred plans. But sometimes the amount you invest is also tax deductible, saving you even more. And with a Roth IRA, although you're not allowed to deduct the money you put into it, the money you take out is completely tax free, provided you follow the rules for withdrawal.

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