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Tax Tips for Stock and Fund Investors
Charles Carlson, CFA
Contributing Editor, Dow Theory Forecasts

Taxes have an insidious effect on your portfolio returns, especially over time. Every dime you pay Uncle Sam in taxes, such as capital-gains taxes or taxes on dividend income, is a dime that will never earn you any future returns. It's gone forever. Here are some ways to avoid Uncle Sam in your investment program:

  • Avoid frequent trading -- One reason I like a buy-and-hold investment philosophy is that it is extremely tax friendly. In many cases, selling stock means incurring a tax liability if you have a gain in the stock. And depending on how long you've owned the stock and your tax bracket, your tax liability could be as much as 39.6 percent of your profit. You can lessen the impact of taxes on your investment returns by holding investments for at least 12 months, thus incurring the more favorable tax treatment when you sell.
  • Stocks are usually better investments than other investment vehicles when it comes to avoiding Uncle Sam. With individual stocks, you control your tax destiny; you incur a tax liability only when you decide to sell the shares. With stocks, you can defer taxes indefinitely. You can even wipe out any tax liability on investments if you pass along the investments to your heirs when you die. That's because your heirs receive a "stepped-up" cost basis on stocks that they inherit. Unfortunately, you may not have a say over the tax issue with certain investment choices. If you're ambivalent between owning individual stocks and other investment derivatives, keep in mind the tax advantages of stocks.
  • If you invest in mutual funds, make sure they are "tax friendly." One way to assess the "tax friendliness" of a mutual fund is to examine its "turnover ratio." This ratio measures the level of selling in the fund. A turnover ratio of 100 percent means that the fund manager turned over the entire portfolio once during that year. The lower the turnover ratio, the lower the amount of selling that is done in the portfolio, and the lower your potential tax hit. A number of mutual fund families are developing what they call "tax-efficient" funds. Characteristics of these funds include:
      1. Infrequent selling of fund positions
      2. Minimizing the taxable gain on sales by assigning the highest cost basis possible to the sold shares
      3. Offsetting gains by selling fund holdings with losses
      4. Favoring stocks with modest dividends, since dividends are taxed as ordinary income
    When considering a "tax-friendly" fund, don't ignore index funds, which tend to be very tax friendly.
  • Consider the tax-status of the particular investment account when deciding on investments. Retirement accounts, because they are tax preferenced, are probably better vehicles for holding less tax-friendly investments, such as mutual funds. Retirement accounts are also good vehicles for holding income-generating investments, such as bonds and dividend-paying stocks. Does this mean that you should never hold stocks in an IRA or 401(k) plan? Certainly not. However, it does mean that it's not a bad idea to weight your retirement portfolio a bit toward higher-yielding investments -- total-return stocks, balanced mutual funds, etc. -- in order to maximize the tax benefits. Also, by including mutual funds in a tax-preferenced account, you mitigate the effects of unwanted capital-gains distributions. Conversely, higher-growth potential investments, such as stocks, should be held outside of retirement accounts. In this way, you limit the tax bite by owning stocks (and being able to defer indefinitely capital-gains taxes) and have the ability to exploit losses.
  • Avoid "avoidable" tax transactions. For example, before buying a mutual fund toward the end of the year, make sure the fund has already made its capital-gains distribution for that year. There's nothing more galling than buying a mutual fund, perhaps showing a loss on paper in the fund, yet having to pay taxes on a capital-gains distribution that you receive shortly after buying the fund. Most fund families will tell you the approximate date when a capital-gains distribution is planned. Other common taxable transactions to avoid include writing checks on your bond mutual fund (every time you do this, you incur a potential tax liability) and frequent switches between funds within the same mutual-fund family (switches constitute taxable transactions). Another tax mistake is putting tax-preferenced investments (such as municipal bonds) in tax-preferenced accounts, such as IRAs.

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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