A portfolio examination before year end
Your prescription for fiscal fitness

As we near the end of 2007, it’s a good time to review your investments. A year end checkup can reveal valuable tax-saving opportunities. It also allows you to take your financial vital signs and evaluate whether your portfolio is meeting your objectives. Let’s look at a few key strategies.

Alleviate the tax pain of capital gains

You can reap significant tax savings by “harvesting” some of your unrealized capital losses and using them to offset capital gains you’ve already recognized this year (including capital gains distributions from mutual funds). As you review your portfolio, identify poorly performing investments that you can sell at a loss to reduce your 2007 tax bill.

This strategy is particularly valuable if you have short-term gains, which are taxable at federal ordinary income tax rates as high as 35%. Plus, if you have a net capital loss for the year, you can use it to offset up to $3,000 of ordinary income. Unused capital losses may be carried over indefinitely into future tax years.

In addition to saving taxes, harvesting losses gives you an opportunity to replace losing investments with winners and rebalance your portfolio.

Follow the IRS’s orders

What if you’d like to sell some of the losers in your portfolio to take advantage of tax benefits, but you’re not quite ready to give up on those investments? If you’re confident about a stock’s long-term prospects, can you sell it at a loss to generate a tax deduction and then buy it back to keep your portfolio intact? The short answer is “yes,” but you need to plan carefully so you don’t run afoul of the IRS’s “wash sale” rule.

The wash sale rule prohibits you from deducting a loss on a security if you acquire a substantially identical security within 30 days before or after the sale. You won’t lose the deduction permanently, though. Instead, you add the loss to your cost basis in the replacement security, reducing the gain on that security when it’s sold later.

There are several ways to harvest a loss without giving up the investment. The simplest is to sell a security, wait at least 31 days and then reacquire the same security. Of course, this strategy can backfire if the investment rebounds before you buy it back.

The best way to hedge your bets, if you can afford it, may be to “double up” on the securities and then wait at least 31 days before unloading your original investment. If the price stays where it is, you get the best of both worlds: a deductible loss without disturbing your portfolio. But if the price increases during the waiting period, you still enjoy the rewards.

Another strategy for avoiding the wash sale rule is to sell securities at a loss and immediately buy securities that are similar — but not identical — to the ones you sold. For example, you might replace stock in one company with stock in a comparable business in the same industry.

Diagnose your highest cost basis

Most people buy stocks or mutual funds at different times and at different prices. When you sell them, the amount of gain or loss depends on your cost basis. If you sell less than all your shares in a particular investment, there are various methods for determining your basis, including the first-in, first-out (FIFO) and average cost methods. But to minimize your gains or maximize your losses, you’ll want to sell the shares with the highest basis. The “specific identification” method allows you to direct your broker or financial advisor to sell specific shares.

Let’s say, for example, you bought 1,000 shares of a particular stock on Dec. 1, 2005, for $10 per share and another 1,000 shares on Dec. 1, 2006, for $20 per share. In December 2007, you decide to sell 1,000 shares, when the market price is $15. If you don’t specify which shares you’re selling, FIFO applies, which presumes that you sold the shares you bought in 2005 for a $5,000 gain. If you instruct your broker to sell the 2006 shares, however, you’ll have a $5,000 loss.

To take advantage of this strategy, you must identify the shares before you make the sale — check that your choice is reflected in the trade confirmation.

To your health

As you consider your tax-planning options, be sure to look at the big picture. Don’t sacrifice long-term fiscal fitness for short-term remedies. And keep in mind that these are just a few of the ways a year end checkup can benefit your 2007 tax bill and long-term financial health.

Keeping your balance

Typically, when you develop a long-term financial plan, you select an asset allocation formula that reflects your investment goals, time horizon and risk tolerance. Over time, this allocation may shift as certain asset classes outperform others or your goals change.

Year end is a great time to rebalance your portfolio without incurring additional taxes. Perhaps your plan calls for you to place 70% of your portfolio in stocks and 30% in fixed-income investments, but the strong performance of your equity investments has pushed your stock holdings to 80%. If you’re already planning to sell some stocks at a loss to reduce your 2007 taxes, reinvesting the proceeds in bonds allows you to rebalance your portfolio tax-free.

What if you’re lucky enough to have no losses? How can you correct an imbalance in your portfolio without taking a tax hit? One solution is to adjust the holdings in any tax-deferred or tax-free retirement accounts, such as traditional or Roth IRAs or 401(k) plans. You can sell stocks or bonds held in these accounts with no current income tax consequences. •