While I’m not a big believer in letting taxes drive investment decisions, there are times when knowing your options (in terms of taxes) can make a big difference to your investment portfolio. Since we are nearing the end of the year, a few words about investments and taxes are in order:

1) Be careful when you buy mutual funds between now and the end of the year. One of the more aggravating aspects of owning mutual funds is that you can buy a fund, have a loss on paper in the fund, yet receive a capital-gains distribution on which you have to pay taxes. In other words, you pay a tax on phantom gains. The next two months will see mutual funds distributing realized gains to fund holders. If you are thinking about buying a particular fund, make sure you know when capital gains are being distributed. You don’t want to buy just in time to receive the capital-gains distribution and, therefore, an unwanted tax liability. Most mutual funds will tell you when they plan to distribute gains. This is a phone call worth making in order to avoid any unwanted taxes.

2) Let’s say you have realized substantial gains this year and are looking to reduce your potential tax bill. You look around your portfolio and see a few stocks on which you have sizable losses. One strategy would be to sell those stocks with losses to help offset gains. Be aware that if you sell stocks to lock up losses but want to get back into the stock, you need to wait at least 31 days before repurchasing. Now, let’s say you have a stock (with a big loss) that you want to hold, but you don’t think the stock is going to rise sharply in the next 31 days. And you have investment gains that you want to reduce. You can sell the loser, book the losses to offset the gains, and buy back the stock 31 days later. Obviously, you run the risk that the stock will have risen in that time. Of course, the stock could have fallen as well, which gives you a better buying opportunity.

3) Remember that investment gains on investments held less than 12 months are taxed at your ordinary income tax rate. That may mean paying more than 30% of your gains in the form of taxes if you are in the upper tax brackets. Conversely, if you hold investments at least 12 months before selling, the most you will pay is 20% on your gains. The upshot is that owning investments for at least 12 months can yield huge tax savings.

Of course, all of the scenarios above pertain to investments held in taxable accounts. For investments held in tax-exempt accounts (IRAs, 401(k) plans), the tax issues are moot.

Again, I want to emphasize that, ultimately, the quality of the investment should drive whether you hold or sell any investment.

Still, don’t ignore the various tax options you have, especially if you are faced with a big tax hit this year.

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