Using Tax Lots: A Way To Minimize Taxes

by Steven Merkel,CFP®, ChFC (Contact Author | Biography)

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The cuts to the taxes on dividends and long-term gains - as part of the Jobs & Growth Tax Relief Reconciliation Act of 2003 - have many investors jumping to make changes to the strategy with which they hold their fixed-income and equity holdings. Before 1997, the top tax rate on long-term gains was as high as 28%, and dividends were taxed at investors' ordinary income tax rate! Since the new act, investors have been given a tremendous tax break, and now might be the best time as any to sell those big winners in your portfolio while tax rates are low. Here we take a look at how to take advantage of these decreased tax rates for investors.

The Tax Changes
In 2005, the federal income tax rates remain unchanged at 10%, 15%, 25%, 28%, 33% and 35%. But, here's a quick look at how your dividends, short-term capital gains and long-term capital gains will be taxed on your stock, bonds and mutual funds (depending on your tax bracket):

As you can see from the chart below, short-term capital gains will receive the least-favorable tax treatment, and should be avoided in most cases. It is important to note that the reduced tax rate for dividends applies only to qualified dividends. That is, the reduced rate does not apply unless the dividend is received on a security held for at least 60 days during the 121-day period beginning 60 days before the ex-dividend date.

Stocks, Bonds, Mutual Funds	Tax Bracket of 10% or 15%	Tax Bracket of 25% or Higher
Dividends	5%	15%
Short-Term Capital Gains	ordinary tax bracket	ordinary tax bracket
Long-Term Capital Gains	5%	15%

Reporting Your Gains and Losses
The Form 1099-DIV breaks down the ordinary and qualified dividends for you for tax purposes. However, you still need to keep track of your original cost basis on securities that you purchased as you must report your short-term and long-term gains for the year, which is done on Schedule D-Capital Gains and Losses.

When computing the result of your capital gains, the short-term gains and losses are first netted, and then long-term gains and losses are netted as well. You can then net the two results together to compute your overall result. Be cautious of the wash-sale rule which could disallow a loss if you bought or sold shares of the same security within 30 days before or after the sale (see Selling Losing Securities For A Tax Advantage).

Using Tax Lots to Your Advantage
Your choice of cost basis method can have a significant effect on the computation of capital gains and losses when you sell shares. For mutual fund shares, there are three common ways to identify the cost basis of the shares that you are selling: FIFO (first-in, first-out), average-cost method and specific-share method. For stocks, you could use FIFO, LIFO (last-in, first out) or specific shares.

Most people choose to use the FIFO method because it is functional with most software packages, and it's convenient for tracking cost basis. But here we are going to take a look at how the specific-shares method (selecting specific tax lots) can help you minimize your gains versus using one of the two standard FIFO or LIFO methods.

Suppose over a two-year period, you made the following purchases of XYZ stock (you are in the 28% tax bracket):

Tax Lot #	Cost Per Share	Shares	Purchased	Current Price Per Shares	Gain
1	$50	800	two years ago	$75	$25
2	$58	500	nine months ago	$75	$17
3	$70	400	six months ago	$75	$5

Now, suppose that you need to sell 800 shares of XYZ and you want to minimize your tax consequence:

Under the FIFO Method	Tax Result	Taxes Due
Sell 800 shares of tax lot #1	long-term gain of $20,000	$3,000 ($20,000 x 15%)
(800 shares x $25 gain)

User Specific-Shares Method	Tax Result	Taxes Due
Sell 400 shares of tax lot #3	short-term gain of $2,000	$560 ($2,000 x 28%)
Sell 400 shares of tax lot #1	long-term gain of $10,000	$1,500 ($10,000 x 15%)
		Total $2,060

Under the FIFO method, you would sell the first 800 shares that you purchased two years ago, resulting in a long-term gain of $20,000, with a tax bill of $3,000. On the other hand, if you choose to sell a specific tax lot instead, you can sell your most expensive shares first (even though they are short term) and still have a lower tax bill of $2,060.

Strategies for Tax Minimization

Track securities by tax lot - If you keep accurate accounting (cost basis info) of all your purchases, you can sell your highest cost positions first.
Avoid short-term gains - In many cases, it's best to sell your long-term positions first, however; check your tax lots - it sometimes makes sense to sell the newer position for a lower capital gain.
Avoid high-turnover funds and stocks - High turnover in your portfolio will generate commissions, transaction costs and higher tax liabilities. If you're going to do a lot of trading, make sure that every buy and sell decision is worth it from a tax perspective.
Utilize tax-managed funds - These managers invest in the same stocks as other funds, but the managers seek to minimize the year-end distributions of gains by less buying and selling within the fund.
Sell your Losers - Harvest your losses on your positions to use the loss to offset gains, don't be afraid to generate losses that carry forward for future years.

Summary
As you have seen, there are many different methods of determining your gain or loss on the sale of a particular security. Although, first-in, first-out might be the easiest method to calculate and track, it might not always be the most tax advantageous. If you do take advantage of the specific-shares method, make sure you receive a written confirmation from your broker or custodian acknowledging your selling instructions. You must determine the method that works best for you and stick with it.

(For the latest tax and legal developments, chec out the Tax and Law Articles at Forbes.com.)

by Steven Merkel (Contact Author | Biography)

Steven T. Merkel, CFP®:, ChFC, is the vice president of portfolio management for Financial Advisory Consultants LLC in Naples, Fla. Steve is a former U.S. Army air defense artillery officer and has been giving financial advice for more than 12 years. He is a Certified Financial Planner® practitioner and a Chartered Financial Consultant. Merkel has been featured and widely quoted in numerous publications including The New York Times, BusinessWeek, Entrepreneur, Consumer Reports, Investment News, Financial Planning Magazine and Fidelity's Stages Quarterly. He enjoys fishing, golf, military history, Miami Hurricane football and relaxing on the beaches of South Florida.

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