Do you need more options in your year-end tax strategy?

Do you need more options in your year-end tax strategy?

Kevin Kersten, InvestorsObserver

As the end of the year approaches, most investors start to think about taxes. Some carefully thought out moves can usually save some money, get rid of losers and help prepare for another year of investing. This year it is not so simple and a regular tax strategy of selling losers to realize the tax write-off may not apply.

As is sported about in the media there is a coming "Fiscal Cliff." With big spending cuts, tax hikes and changes in the tax code, the US could be in for a bit of a shock. Obama has said he wants higher tax rates, particularly on high income individuals, so extensions on the Bush-era tax relief is unlikely for them.  The deal on raising the US debt limit put in mandatory cuts to spending later, and later has finally come. With the election out of the way, now is the time for the US elected officials to a get a reasonable budget passed.

Budgeting decisions are rarely easy and this year they may be much harder than normal. The economy is feeble with a recovery being very weak. There is a good chance the US could slip into a double dip recession. For the last few years politicians have put off making decisions until later thinking that it would be easier then. Now is later, and it is not going to be much easier. Last year for every two dollars our government brought in, it spent almost three and this does not work well in the long run. The US debt, as a percentage of GDP, has continued to climb and, while not in the crisis zone, we are very close to it. Europe also has major budget and debt issues as its sovereign debt crisis continues to be a big issue that will not go away. 

Now would be a great time for Congress to dive into the budget and make some serious cuts and come out with something close to a balanced budget. A clear multi-year plan could be made where US tax code could be simplified, deductions could be eliminated and pork could be cut. Entitlements and promises may need to be pared back and taxes may need to go up.

Long term, having a clear US tax code that did not make investors wonder or fret about moving around money would be a good thing. The rest of the world would also breathe easier knowing what is going on in the US.  The Australian Foreign Minister, Bob Carr, recently said, "The United States is one budget deal away from restoring its global preeminence."  It is going to take a lot more than just one budget to solve our fiscal issues, but solving them without one may be even harder.

However, regardless of what needs to be done, investors are facing the end of the year with a bit of tax uncertainty. Taxes on dividends are set to expire this December and several stocks have been moving dividends up so that that they are paid in 2012 instead of 2013. The Alternative Minimum Tax has not been "patched" this year.  Congress has extended the special treatment of dividends several times in the past and may do so again. It may also be extended for some tax payers and not others. If taxes on dividends were to rise, the dividends investors get to keep falls and the stock becomes less valuable, according to the reasoning a stock is only as valuable as the future payment of all its dividends. Stocks high in dividends like AT&T (T), Johnson and Johnson (JNJ), Microsoft (MSFT) and Wal-Mart (WMT) could see selling pressure.

Stocks that have risen a lot could also see some selling pressure. Money has a time value to it and normally taking a tax write-off immediately is beneficial. However with capital gains tax rates likely going up, it might be better to book profits this year at a lower tax rate than next year at a higher tax rate. This means stocks that have gone up this year may face selling pressure as well. That could include stocks like EBAY as well.

These stocks might see a short-term dip around the end of the year as investors sell them, and then bounce back later in the New Year. If capital gains or dividend taxes are permanently raised by Congress, the stocks might not regain their previous stock price.

Each investor should take a look at their portfolio, stock holdings, likely tax rates and future intentions with regards to stock positions. It may well make sense to sell a dividend stock or take profits on a stock that has risen significantly. Certainly there is a time and a place for selling stocks, but selling the stocks on the possibility of a change in taxes may not be the best thing. The taxes might not change. One might need to consider how long you have been holding the stock. Are you facing long-term or short-term capital gains? If you are facing short-term capital gains, how much longer do you need to hold the position until you are facing long-term capital gains?

Options bring other choices onto the table as well. While most investors sell a covered call in order to bring in premium -or rent like payments- on a regular basis, one can sell covered calls that are deeper in the money to provide some additional downside protection. This protection could last well through the end of the year selling and into the New Year. The position can also be closed early as well.  If one sells a June call in December, one can buy it back in January and not hold the position until expiration. 

EBAY, the famous online auction site, has done well over the last year and the stock has gone from 30 to 49 in price.  The stock has a three STARS hold rating and has seen strength in both earnings and revenues.

With the recent appreciation, EBAY could be ripe for selling so investors take profits this year at lower tax rates. But if you don't want to sell the stock, you could sell a call option on the stock.  Take a look at the EBAY April 46 covered call for a net debit of 43.30. This call has a 6% assigned return over four months, a 16% annualized return rate (for comparison purposes only), and 11% of downside protection.  If the 11% downside protection is not enough for you, check out the other strikes. (At times, investors like to overemphasize the moves stocks will make and I don't think the profit taking is likely to move EBAY more than 10%.)

My calculations assume you are buying the stock at today's prices and are entering it as a combined trade not including commissions. If you already own the stock your cost basis is going to be different, so your profits are likely to be different as well. I am also assuming you hold the option until expiration and that it is assigned. Whether one wants to sell the stock at expiration or close out the option before through buying it back is something one needs to decide shortly before expiration. There are lots of things that could happen between now and then.   

As you review your portfolio going into the end of the year and you are worried about dividend stocks dropping because they are less desirable due to taxes going up or people dumping winning stocks to book the gains at lower tax levels, consider using an in-the-money covered call to offset the risk. This is a secondary tool. If the stock is really going to drop you need to sell it; but if it is flat, drifting up or drifting down moderately, a covered call can provide more protection on it and make you feel better through the dips.  Ultimately, if you profit from your investments, the government is going to want to get a piece of the action; but we can still wisely maximize our returns.

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