Taking Care of Year-End Business

Dec. 14, 2011— -- intro:As the end of the year approaches, there are some steps investors may want to take to keep Uncle Sam from taking too much of their hard-earned money, and to maximize their investment returns. Before you sing "Auld Lang Syne," consider these moves:

quicklist:title: Paying into your retirement plans. text:Contributions to 401(k) plans and IRA accounts are tax-deferred, meaning that you aren't taxed on this money until you withdraw it —preferably when you're retired and in a lower tax bracket. So contributing to these plans is an excellent way to get tax deductions while saving for retirement. Although you have until April 15 to make these contributions for the 2011 tax year, it's important to think about them now as part of your tax-planning strategy.

One advantage of the retroactive deadline is that investors who find after Dec. 31 that they have the wherewithal to contribute additional amounts to their plans can do so — and those who don't have accounts can establish them to cut their 2011 taxes.

quicklist:title: Converting assets to a Roth IRA.text:This means taking money out of a tax-deferred retirement account, such as a 401(k) plan or IRA, and putting it into a Roth IRA to take advantage of this investment's potential advantages. When you do this—called a Roth IRA conversion—you must pay taxes on the money that year. The good news is that the growth of assets in a Roth IRA is tax-free--subject to rules including penalties for early withdrawal.

Roth conversions this year can be a winner for people who anticipate substantially higher taxable income — or a likelihood of higher tax rates — in future years. Also, the longer you wait to tap these accounts, the more time there is for investments in your Roth IRA to grow tax-free.

One approach would be to convert some, but not all, money from IRAs and 401(k) accounts, and then maintain an IRA/401(k) bucket and a Roth bucket. In high-earning years, you could take money out of your Roth bucket tax-free. In lower-earning years, when your tax exposure is lower, you could take money out of your IRA/401(k) bucket.

quicklist:title: Taking gains or losses on investments for the 2011 tax year.

text: Gains result in taxable income while losses result in deductions in the year that investments are sold. Professional investors commonly speak of strategic loss "harvesting" to minimize taxes. This strategy is essential to maximizing net returns. But this shouldn't become an end in itself.

Instead, decisions should be driven by the goal of enhancing your portfolio, as opposed to just lowering taxes. Just because you have a loss on a stock that can get you a deduction in 2011, this doesn't mean you should sell the stock.

The question is: Is there a stock you'd like to buy that you believe would be an equal or superior investment?

For example, let's say you own Exxon and have lost money on it in 2011. Chevron looks better to you, so you sell Exxon and buy Chevron, maintaining your exposure to the energy sector and increasing your potential for gain. But if you don't have a replacement for Exxon, perhaps you shouldn't sell it this year — especially if it has potential to rebound and you expect to have more taxable income in 2012.

The same logic applies in selling investments to take gains. If 2011 is a lower-taxable-income year for you than you expect in 2012 and you're looking at selling a stock, resulting in a taxable gain, you should ask yourself: What could I replace it with? There's no doubt that basing these decisions purely on taxes can lessen your tax bill. But if this approach is carried to an extreme — if taxes are the dominant consideration — this can result in an ever-diminishing portfolio. Ultimately, you might end up paying no taxes because you wouldn't have any investments. All other factors being equal, taxes can be the deciding factor, but don't let tax considerations drive your investment bus.

quicklist:title: Using ETFs to maintain market exposure.text: If you believe there will be good returns in a certain sector of stocks next year but you've lost money in this sector in 2011, you may want to sell the stocks and take the tax deduction, and then buy back into the same stocks next year after the required 30-day interval. Of course, there's no way to know when a sector may bounce back, but you must be invested to get the benefit of lucrative sector spurts.

A good way to avoiding missing out on returns from such spurts that occur between the time you sell stocks and buy back in is to buy shares in exchange-traded funds (ETFs), funds traded on exchanges that are pegged to the performance of stocks in certain sectors. For example, you could sell underperforming tech stocks this month, take the tax deductions and then park the money from the sale in tech ETFs until the required 30-day interval passes. Then you buy back into the sector. This way, you can get the deduction but stay in it to win it.

quicklist:title: Contributing to college savings plans. text: Primarily, the tax benefits of these plans, known as 529 plans, come from savings on state taxes. So check the rules for your particular state to see what the difference might be in taxes for paying into these plans this month as opposed to next year.

quicklist:title: Making charitable donations. text: By helping people in need this holiday season, you can reap savings on your 2011 taxes. If there are non-profit organizations you plan to support, now is the time to make donations. This way, you'll have had the benefit of using the money all year and still get the tax break.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group. He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at ted@capstoneinvest.com..