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Market Downdraft Clears the Air
By Stephen J. Butler |
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A few days after April 15th is a good time to reflect on what we might have done differently to reduce the size of those checks to the federal and state governments. Reducing the tax "hit" on investment returns is one of the most constructive steps we can make to improve results with 100% certainty. By comparison, all the emotional and intellectual effort we spend on changing investments and shifting our asset allocation may or may not lead to an increase in our net worth. All too often, we just snatch defeat from the jaws of victory. When it comes to results, too much is out of our control and beyond our ability to predict.
Over here on the sunny side of the street, the downturn in the market offers a wonderful opportunity to make some adjustments without the usual fear of triggering taxable capital gains. In the old days of the nineties, selling an investment to move the money elsewhere generally triggered a tax on a gain. We would say to ourselves, "I really should move that money into something else, because this can't go on forever. But, if I do it now I will have this big gain, and the resulting tax will chew up at least 20% of what I have made. Hmmm. I think I'll wait awhile longer?"
This time it's different. The chances are that at least some of your investments are even with what you paid for them and some are probably under water. Here's a window of opportunity to make major investment adjustments without having the IRS as our partner in the decision. As Martin Luther King would have said, "We're free at last."
The opportunities for improvement start with mutual funds that are operated with an eye to reducing taxes as much as possible. Most of us have had the experience of receiving a 1099 from our favorite mutual fund spelling out what we had as taxable income for the previous year. Profitable stock trades accomplished by the fund during the year triggered taxable income, and our proportionate share of that income was reported to the government. If we sell our mutual fund shares years from now for more than we paid for them, we will have to pay taxes on the gain. However, we get to subtract from the ultimate gain any of the previous gains that were reported to us during the years we owned the fund.
Two types of mutual funds make this annual tax nibbling go away. In the end, you will pay taxes on what hopefully will be a big gain resulting from many years of buy-and-hold investing. If you can avoid paying taxes along the way, however, you will wind up with more money to work with when you need it for retirement. The idea is to create a nest egg as large as possible. If you have to pay taxes when you start spending the money, then, believe me, having serious income tax problems as a retiree is one of the most delightful problems anyone could hope to have.
The two fund types offering some annual relief are tax-managed funds and index funds. Tax- managed funds are those whose managers specifically trade stocks with an eye to creating "wash sales" or gains with offsetting losses. The second type of fund is an index fund that invests in a broad cross section of the market and then trades very rarely. The "turnover" on an S&P 500 index fund can be as little as 1% per year. This means that very few stocks are ever sold. The gains in value are said to be "unrealized" and investors avoid receiving 1099 tax reports of any consequence at the end of the year.
Yet another option is to transfer non-retirement assets bit by bit into an IRA. Most people who are offered company retirement plan opportunities at their jobs only qualify for after-tax IRA contributions. If you have any money outside an IRA, go ahead and use it to make this contribution. You won't get a tax deduction for it, but you will shelter the gains from taxes until you eventually spend the money to fund retirement. If you don't exceed the income limits for a Roth IRA and further comply with the rules for a qualified Roth distribution, you will never pay any tax on the money you spend from the account.
Most people don't take advantage of after-tax IRA contributions because there is no current tax benefit. However, money compounding at 10% doubles every 7.2 years. A $3,000 contribution this year could have accumulated to $24,000 in about 21 years, and none of the $21,000 in gains would have been taxed. Moving $3,000 EACH YEAR for the next 21 years will accumulate to $192,000. Roughly $129,000 of that money is gain that accumulated free of any taxation. Eventually, these gains will be taxed when we spend them in retirement, (unless they come from a Roth IRA) but the important fact is that they will be there when we need them.
For money in individual common stocks, you may have something valuable in a stock that you want to continue owning but that has lost money since you bought it. You can sell the stock for a loss and buy it back after 31 days. This allows you to apply that loss to any gains you might have made elsewhere in your portfolio on investments you bought years ago and that would actually trigger a taxable profit if you sold them today. Use those painful losses to harvest your gains with impunity.
For many people, it is depressing to try to think of ways to save taxes. Those new to the investment world have enough to think about just getting through the basics. Considering the many tax considerations demands an entirely different level of expertise. Our natural tendency is to just resign ourselves to the inevitable. If you feel yourself sinking into this mindset, remember that $1,000 in tax savings, for most people, is equivalent to a $1,724 raise in taxable job income. It doesn't matter if we're saving taxes on job income or our investment income. It's all bubbling in the same pot. The last few dollars of most incomes are taxed at about a 42% rate when federal, state, social security and medi-care taxes are all added up. (How much more "take-home" pay did you receive from your last raise?) If you can save $1,000 of after-tax income that would otherwise have disappeared in taxes, it amounts to the same net benefit generated by $150 per month increase in gross pay. If that's not motivation, I give up.
The securities markets are subject to the risks of fluctuating prices and the uncertainty of rates of return and yields inherent in investing and past performance is no guarantee of future results.
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