Uncle Sam, Investment Partner
Charles B. Carlson, CFA
Contributing Editor, Dow Theory Forecasts

You are in a business partnership with a friend. Your friend gives you the following choices for splitting the profits:

Pay him 40 percent of the profits at the end of every year.

Pay him just 20 percent of the profits, and you can pay him one year from now, five years from now, 20 years from now, 50 years from now, whenever. You choose when you want to pay.

Which offer would you take? Only a fool would choose the first option, right? You'd be surprised how many fools there are in this world.

Whether you like it or not, Uncle Sam is your investment partner. The more your investments make, the more he makes.

But like the partner in our example, Uncle Sam gives you some attractive options for paying his share. You can pay Uncle Sam up to 40 percent of your investment gains at the end of every year. Or you can pay a maximum of 20 percent of your investment profits, and defer payment indefinitely.

Trim Taxes By Holding Stocks For A Long Time
Uncle Sam gives you a huge tax break if you hold investments for 12 months or more. Indeed, if you are in the top tax bracket (39.6 percent), the tax savings of holding investments for a year or more are 100 percent (20 percent long-term capital gains tax versus 39.6 percent tax on short-term gains).

Let's say your investment portfolio has a profit of $5000 after six months. If you sell (and you are in the top tax bracket), Uncle Sam gets roughly 40 percent of your profit, or $2000.

By waiting just six more months to sell, Uncle Sam's take gets cut in half ($1000, or 20 percent of your profit).

Of course, I'm making the assumption that the $5000 profit still will be around if you wait another six months. Perhaps it will; perhaps it won't. Who knows, it might even grow to $7000. You don't know for certain. What you do know for certain is this. Even if your profit declines by 20 percent in that six-month interval (from $5000 to $4000), you'll still be ahead of the game by waiting 12 months to sell. When you sell with a $5000 profit after six months, your take, after Uncle Sam's cut, is $3000. If you wait until 12 months to sell, and your $5000 profit has shrunk to $4000, your take, after Uncle Sam's cut, is $3200 ($4000 times 80 percent).

By waiting six months, you still come out ahead even if your investment profits shrink by 20 percent.

Smart investors play the percentages. What you know for certain when you sell investments prior to holding them for 12 months is that you'll get a big capital-gains tax bill. That's a given. What you don't know is if the new investment will do any better than the one you sold.

Moral of the story: Uncle Sam is making you an offer you shouldn't refuse. All things being equal, you can't afford not to hold investments for at least 12 months. The tax savings are just too great.

More about taxes:
 Taxes 101
 Investing With Uncle Sam's Money
 Tax Tips for Stock and Fund Investors
 Uncle Sam, Investment Partner

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