Giving Your Stock Portfolio a Year-End Face Lift

Giving Your Stock Portfolio a Year-End Face Lift
By JASON ZWEIG

'Tis the season to dump last year's folly.
The market meltdown of 2008 gives you the rare opportunity for a triple whammy: You can transform your losers into winners, remain fully invested and cut your tax bill to boot.
Plus, you earn the satisfaction of taking action when so much of your investing destiny otherwise seems to be out of your hands. Yet these actions, unlike such drastic steps as dumping all your stocks, are very likely to leave you better off in the long run.
That makes this month the ideal time to beautify even the most battered portfolio.
Of course, it is hard to make peace with your losses. Selling a loser forces you to admit a mistake; it also forces you to make what might be a second mistake. What if you move the money into something that does even worse? Hamlet was right: We would "rather bear those ills we have than fly to others that we know not of."
To ease the pain of selling a loser, replace it with something that feels similar. Say you bought 100 shares of Exxon Mobil in October 2007 at $95. Your $9,500 investment is now worth less than $7,700. Sell Exxon Mobil and immediately buy another energy stock. A recent study by investment strategist James Montier of Société Générale in London finds that Chevron, ConocoPhillips, Marathon Oil, Tesoro and Valero Energy all meet several of the standards for investment value set years ago by the great analyst Benjamin Graham.
Better yet, sell Exxon Mobil and put the proceeds into a basket of oil stocks like Energy Select Sector SPDR or Vanguard Energy ETF. This way, you decrease your risk by increasing your diversification, yet you maintain 100% of your exposure to energy stocks while they are on sale.
In each case, you can use the $1,800 loss to reduce your tax bill by offsetting capital gains you may have elsewhere now or in the future. That would become even more valuable if the Obama administration raises the tax rates on capital gains.
There are other ways to clean up by cleaning up. Say you own an index fund that holds all the companies in the Standard & Poor's 500. Sell at a loss, buy a total stock market index fund that holds everything in the Dow Jones Wilshire 5000 index, and voilà: less risk, more diversification, equal exposure to stocks and a lower tax bill.
Just be sure the new fund isn't what the IRS regards as "substantially identical" to the old one; so long as it tracks a different index you should be fine, says James A. Seidel of the tax and accounting business at Thomson Reuters.
Next, consider cleaning up your individual retirement account. If your adjusted gross income won't exceed $100,000 this year (and you don't file a separate married return), you can convert a traditional IRA to a Roth IRA.
The bear market has shriveled not just the value of your old IRA but also the tax liability you will incur on the conversion. "Converting makes more sense now than it has at any point in history," says Gary Schatsky, a financial planner in New York. An IRA that was worth $50,000 a year ago may be worth only $30,000 today; switch to a Roth now, and you cut your conversion taxes roughly 40% below what they would have been in 2007.
That smaller hit today means much bigger savings tomorrow. In general, once you convert to a Roth, all future withdrawals from the account are tax-free to you -- and to your heirs.
Finally, if you already converted a traditional IRA to a Roth earlier this year thinking the market had bottomed, don't just lick your wounds; call a do-over. Remarkably, you can transform your Roth back to a traditional IRA. Instruct the trustee of your account (your bank, broker or fund company) to "recharacterize" the IRA. That erases your original conversion and the taxes you would have owed on it.
Then wait 30 days after the recharacterization date and convert again to a Roth. Chances are, the market will be in the dumps next month, too, enabling you to convert at an even more opportune price this time.
For more guidance on tax swaps and Roth moves, see IRS Publications 550 and 590 (www.irs.gov/publications); be sure to walk through the requirements with your tax adviser to confirm that you qualify. You wouldn't want to miss out on the chance to clean up by year's end, but you wouldn't want to mess it up, either.
Write to Jason Zweig at intelligentinvestor@wsj.com