Taxes And Your Investments

Why worry about the taxes your stock investments generate? Top-tier performance will compensate for any bite the government takes out of your profits. Anyway, that bite has become a nibble, with recent cuts in the federal long-term capital gains rate. Right?

Wrong. The only investments for which taxes don’t much matter are those in individual retirement accounts, employer-sponsored 401(k) plans, and other tax-deferred vehicles. For holdings outside such shelters, considering tax consequences should come right behind determining investment horizon, objective, and risk tolerance when you’re making your mutual fund and individual-security choices.

“Taxes aren’t the be-all and end-all,” explains David Pear, president of Beecher Investors, a New York-based investment management firm. “But if you don’t include taxes as a real cost, you’re open to making very large mistakes in optimizing your portfolio.” It’s not what you make but what you keep that counts. And you’ll keep more if you control two factors: expensesÑyour trading costs and management feesÑand taxes. Of the pair, taxes matter more. Just compare a 1 percent yearly fee levied by a fund with the 28 percent or more appropriated by the Internal Revenue Service.

“People get hung up on fees,” notes Leonard Reinhart, chairman of Malvern, Pennsylvania-based Lockwood Financial Group. “The reality is taxes are by far the most substantial penalty.”

Taxes and your Investments

The best way to avoid this penalty is to minimize selling, particularly of investments you’ve held for a year or less. Quick profits are considered ordinary income, as if you’d earned the money on the job. Short-term traders in the top 39.6 percent federal bracket are handing the tax man nearly 40 cents of every $1 gained from selling their well-researched picks, not to mention what they fork over to their brokers and state-tax collectors. Think of it this way: If you knew the stock market would plummet 40 percent, would you buy?

The new capital gains cut doesn’t help much either. Congress delivered a gift-wrapped package to investors but socked it to traders. Although the rate at which your long-term gains are taxed falls to 20 percent from 28 percent, to get the biggest break you have to hold shares longerÑ18 months instead of 12. Between a year and 18 months, the old 28 percent rate applies; less than that, and your gains are taxed as income.

Of course, even 20 percent is a pretty big chunk to give up to the government every year and a half. You can, though, arrange to get an almost-free pass: Just let your winners ride. Buy shares of companies you expect to prosper over the next decade or two, and hold on to them. The longer you can defer realizing your gains, the more of your dollars will be invested and keep growing. “It’s a very key component of the formula for making money,” says Robert Torray, who manages his Torray Fund with tax efficiency in mind.

Buying to hold is perhaps the single best way to construct a tax-efficient portfolio. But you can leverage this basic strategy’s benefits by combining it with a few tax-saving tactics:

• Invest in stocks that don’t pay dividends. Warning-this approach could alter your asset allocation, and you might have to rethink your risk-tolerance. A tax-sensitive portfolio will tilt toward growth stocks, which generate capital appreciation, and away from value plays, which tend to deliver more of their total return through dividends. James Poterba, an economics professor at the Massachusetts Institute of Technology, found that the optimal portfolio mix of stocks and bonds changed significantly when after-tax returns were considered. The pretax portfolio looked like this: 40.4 percent large-capitalization stocks, 17.4 percent small-capitalization stocks, and 42.2 percent long-term U.S. government bonds. But the after-tax portfolio allocated just 28.6 percent to large stocks, nearly doubled the small-stock weighting to 34 percent, and trimmed the bond portion to 37.4 percent. Why such a jump in small stocks? Because most pay little or no dividend.
• Whenever you sell a winner, make sure to unload a loser before the tax year is over. Depending on its size, your capital loss will reduce or completely wipe out your taxable gain — whether short- or long-term. And you’re allowed to carry forward excess losses indefinitely to offset future gains. (You can buy back losers you think will rebound, but wait 30 days or the IRS won’t allow the offset.)
• When selling off part of your position in a stock, start with the shares for which you paid the most. Using this accounting method — known as HiFo, for high-cost in, first out — you register the smallest capital gains and pay the lowest taxes. For individual stocks, the record keeping is fairly straightforward. With mutual funds, you have to tell the fund family or your broker to sell shares bought at a certain price. Otherwise, the fund will calculate the sale at your average cost.
• Buy insured municipal bonds instead of U.S. Treasuries. Government-bond interest is exempt only from state, not federal, income tax. Munis are completely tax-free, as long as you stick to those issued by your home state. Investors in the highest tax bracket benefit most: At the top rate of 39.6 percent, a 10-year Treasury paying 6 percent generates a 3.62 percent after-tax yield; an equivalent triple-A-rated insured muni yields north of 4 percent. Below the 36 percent bracket, the advantage of munis over Treasuries becomes less clear-cut.
• Die. It’s extreme, but death is still the ultimate tax-avoidance ploy. If you own 1,000 shares of Microsoft bought at a split-adjusted $10 a share, and they’re selling at $100 when you die, your heirs inherit the stock at a stepped-up cost basis of $100; the $90,000 capital gain is forgiven. The full $100,000 position will be assessed at the estate rate, but even estates are getting a break. Over the next 10 years, the amount an individual can give away while alive or transfer at death without incurring taxes will increase to $1 million from the current $600,000.

All these strategies and tactics apply to your fund holdings as well as to your individual-stock positions. The catch is, you have real control only over your own trading; your funds’ managers do pretty much what they want. And most don’t make tax efficiency a top priority. That’s largely because investors haven’t forced them to. Fund advertisements and tables trumpet their pretax returns. You should demand the after-tax figures as well. Once a year, mutual funds distribute the dividends they’ve collected together with the capital gains they’ve realized, and as a shareholder, you are taxed on the payout whether you reinvest or cash it. In fact, you’re worse off than you are with individual stocks, since you can get soaked even when your fund loses money: If heavy shareholder redemptions in a down market require managers to liquidate positions, taxes must be paid on any realized gains.

Just as for your own portfolio, the most tax-effective strategy for a fund is bare-minimum trading. This is indicated by a low turnover rate. Annual turnover, which is disclosed in a fund’s prospectus, is a measure of average buying and selling activity. A fund with 100 percent turnover holds its positions, on average, for one year before selling them; one with 50 percent turnover trades its entire portfolio every two years.

It’s true: You can’t evade death or taxes. But with careful planning and discipline, you can avoid death by taxes.