Tips for Stock and Fund Investors
Charles Carlson, CFA
Contributing Editor, Dow Theory Forecasts
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:
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.
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.
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
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.
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.
"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.
With Uncle Sam's Money
Tips for Stock and Fund Investors
Sam, Investment Partner
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