Tax-Smart Investing. Part 1

Although the ink is barely dry on last year's tax returns, it isn't too early to start thinking about reducing your 2001 tax bite. Like many investors, you may have been advised not to let tax considerations determine your investing strategy. This is reasonable advice if all your investments are in a tax-deferred account, such as an IRA or 401(k) plan. However, if you have a taxable investment account, you can boost your returns significantly by following a few tax-smart investing guidelines.

Stock investors are subject to two types of taxes on their investments: taxes on dividends and taxes on capital gains.

Dividends

Dividends are taxed as ordinary income at your marginal income tax rate. The only way to avoid these taxes is to invest in non-dividend-paying stocks in your taxable account. Ideally, all stocks with high dividend yields should be placed in your tax-deferred account. This strategy works well for people with flexible retirement accounts like IRAs. Most 401(k) and 403(b) plans preclude investing in individual stocks. In this case, you can still minimize your taxes by favoring stocks with low dividend yields or no dividends in your taxable account. To check on a stock's dividend yield ("yield"), go to finance.yahoo.com, plug in the stock symbol and ask for detailed information. Any dividend yield below 1% is considered rather low.

Capital Gains

Capital gains are the profits you make when you sell stocks that have gone up in value. If you buy a stock today and sell it within the next 12 months, the capital gains will be taxed at your marginal income tax rate. If you hold the stock for at least one year before selling it, your gains will be taxed at a rate of 20%. This results in substantial savings if you're in one of the higher tax brackets.

Clearly, it is advantageous to hold onto an appreciated stock for at least a year. You can forestall capital gains taxes indefinitely simply by keeping the winners in your portfolio. However, you may have a good reason for selling a winning stock. In that case, you can still avoid paying a capital gains tax if you offset the gain with a realized capital loss. To realize a capital loss, you simply sell a stock that has dropped below your purchase price. In a large portfolio, you'll always have some winners and some losers, so it shouldn't be too hard to cull a stock that has performed poorly. If your realized capital losses exceed your realized gains over the course of a calendar year, you can use the net losses (up to $3,000) to offset ordinary income in calculating your income tax. This is a wonderful little tax break. Any net losses in excess of $3,000 are carried forward and can be used as a tax deduction in future years.

As a topic of interest, taxes range from tedious to mind-numbing, and are therefore ignored by too many investors. It's worth the extra effort to become a tax-smart investor. In an uncertain world, tax-efficient financial management is almost guaranteed to put more money in your pocket. Next month, we'll tackle the related topic of taxes and mutual funds.

May 1, 2001

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