Minimizing
Taxes and Maximizing
Profits on Your Investments
With 1999 going down in history, as the year the
Dow soared beyond the magic 10,000 mark, there’s a good chance your own
portfolio registered all-time highs, too. Before you count your new-found
riches, though, make sure you’re tax smart when you manage the capital gains,
or you’ll find yourself writing out a record-sized check come next April. If
you don’t address important tax considerations, you may be unnecessarily
frittering away your profits. It’s not how much you make
that count, it’s how much you keep.
Some Basic Definitions
A capital gain is the profit you realize when you
sell stock or other capital assets that have appreciated in value. The tax
treatment of a capital gain or loss depends on how long you own the asset before
you sell it. Gains or losses on the disposition of assets you’ve held for
longer than 12 months are treated as long-term gains or losses, which means the
gains are taxed at a more favorable maximum rate of 20 percent (10 percent for
taxpayers in the 15-percent tax bracket). Gains or losses on the disposition of
assets you’ve held for 12 months or less are viewed as short-term gains,
whereupon the gains are generally taxed at a higher rate, that is, whatever
you’re currently paying on ordinary income. Thus, these rates can range from
15 percent to 39.6 percent. Investing wisely includes minimizing your tax burden
while maximizing your gains.
Not All Growth Funds are
Created Equal
Buying growth stocks or growth mutual funds can be
advantageous because most of your returns come from capital gains, unlike
returns on income stocks and funds, which come mainly from dividends and
interest. Here is the key difference: income from dividends and interest is
taxable at ordinary income tax rates.
Keep in mind that growth funds — that is, groups
of assets managed by a single company or individual — lack some of the tax
advantages enjoyed by growth stocks. Every year, the fund has to pay you a pro
rata share of any net capital gains it earned when it sold securities. You then
must pay taxes on those gains. Therefore, when buying a fund, check its
tax-efficiency ratio — the percentage of total return that an investor keeps
after taxes. The higher the ratio, the better it is. Also, some funds hold
stocks that have appreciated greatly since the fund bought them. When the fund
finally sells, you can be stuck with a hefty tax bill. Therefore, if you are
choosing among otherwise equally attractive funds, check the funds’ annual
reports and choose the ones that have fewer unrealized gains.
Use The Right Basis
To calculate the profit you made on your stocks or
mutual fund shares, subtract your basis (the cost of the shares plus any
up-front sales fees) from the proceeds of the sale. If you bought your shares
all at once and then sold them all at once, the math will be a snap. However, if
you bought your shares in blocks or by reinvesting dividends, or if you sold
only a portion of your shares, figuring your basis can be a lot more
complicated. For stocks, you need to figure out your gain for each block of
shares purchased at different prices.
With mutual funds, you can take the easy way out
and use the average basis, which most mutual fund companies now report to you on
an annual statement you generally receive in February.
For both stocks and mutual funds, in order to
reduce your taxable gain, you can choose to sell a group of shares you bought at
a higher price, but you must use the actual
cost of the shares that you instructed the fund to sell, not the average
basis. For this method, you must have specified to your broker or other agent
the particular shares to be sold at the time of the sale and have received
written confirmation of your specification. Keep in mind: once you choose a
method, you have to stick to it for future calculations, unless you get IRS
approval to change it.
Write Off Your Losses
When you sell securities for a gain, comb through
your portfolio for losers. You’re allowed to write off losses
dollar-for-dollar against your capital gains plus an additional $3,000 of
ordinary income like salary and interest. If you have no capital gains, you can
deduct the losses against up to $3,000 of ordinary income.
If your capital losses over the course of the
calendar year exceed your capital gains plus $3,000 of other income, you can
write off the excess in future years. Just don’t forget about these carryover
losses in later years.
Replace Losers You Like
If you take a taxable loss on your depressed fund
or stock and then it rebounds shortly after you sell it, make sure you wait more
than 30 days after the date of sale before you buy it back. If you buy or sell
identical securities within a period of 30 days before or after the date of
sale, the so-called “wash-sale” rule won’t let you take a loss. Another
way to take advantage of the uptick without losing the capital loss would be to
buy stock in different companies within the same industry, or mutual funds in
the same category.
Replace Winners You Like
The wash-sale rule does not apply when you realize
a profit on the sale of your asset. You can sell one of your winners to balance
a loss and then buy it back immediately. Though you’ll have to pay a
commission for the purchase, you’ll also have the added tax bonus of a higher
basis for your new shares.
Don’t Jump The Gun
If
your reason for selling is to take profits, rather than to offset losses, sell
shares you’ve held for more than 12 months. That way you’ll qualify for the
capital-gains rate of 20 percent. However, if you don’t need the cash and
aren’t planning to reinvest, hold on to those high-performing stocks. Remember
that a stock you bought for $10 a share may soar to $100 a share, but you
don’t owe a penny in taxes until you sell the stock.
Be sure that you do not base your decisions solely
on a desire to save tax dollars; be sure your actions have a solid investment
rationale.