Seeking Income? Think Outside the Box

Current interest rates are at rock-bottom levels, and they’re likely to stay there for a while, according to recent comments from U.S. Federal Reserve Board Chairman, Ben Bernanke. It’s good news in some ways, not so good in others, because where, in such an environment, can you turn for income?

Most investors divide their portfolios into two buckets. One is principal, which comprises the assets in the portfolio, and the other income, which is made up of the interest and dividends the assets provide.

According to conventional wisdom, you can certainly live off your income in retirement, but whatever you do, don’t tap into your principal. If you do, you’ll have a smaller nest egg, which will in turn yield less income.

While it’s wise to have a base of assets that never falls below a certain level, it may pay to think of income differently. It’s possible, for example, to generate your own income – by selling some of your assets. We’re not talking about reducing your original principal, but about harvesting gains from your portfolio.

For example, you have a $500,000 portfolio that generates 6 percent ($30,000) annually in interest and dividends, and you’re taking that amount as income.

Now, let’s say your portfolio has a good couple of years, and rises to $600,000. One option is to continue to take the 6 percent in interest and dividends (now $36,000) as income. Another option would be to sell a portion of your portfolio – no more than $100,000 – so your principal will still be $500,000.

If you choose this approach, you’ll be selling your winners or other stocks you think are appropriately valued. But be aware: Doing so can generate capital gains.

It’s wise to consult with an advisor to ensure that the resulting gains are long-term (which are taxed at the capital-gains rate), not short-term (which are taxed at your regular income-tax rate).

Turn Losses into Gains with a Capital Loss Deduction

Capital-loss deductions are a great way to take the sting out of investment losses and save some money on your taxes at the same time.

A capital loss is the loss of money incurred when a capital asset (such as investment or real estate) decreases in value and is then sold.

When you have a capital loss, you must first use it to reduce any capital gains you have on other investments, and there is no dollar limit for doing so. When your losses are bigger than your gains, you have capital losses left over; these capital losses can be deducted from your income by up to $3,000 per year (or $1,500 if you’re married and filing separately from your spouse).

If your losses exceed $3,000, you can carry them forward to future years indefinitely; there is no limit on how much you can deduct in capital losses, other than the annual maximum of $3,000.

For example, if you have $50,000 in annual income for 2013 and $5,000 in capital losses, you can deduct $3,000 of those losses in 2013 (reducing your taxable income to $47,000). You can then carry the remaining $2,000 forward to the following year, when you can deduct it from your 2014 income.

Investors often ask if the $3,000 annual maximum will be increased, and the answer is no – not in the foreseeable future. The issue is not receiving any attention in Congress. Why not consider capital losses for your 2013 tax return, and turn your losses into gains?

The tax information in this article is merely a summary of our understanding and interpretation of the current laws and is not exhaustive. Please talk with your advisor for advice about your individual situation.