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Ten steps to avoid the biggest investment goof of the 20th and 21st centuries
by Charles Wolpoff
The goal of investing is to make money by buying stocks low and selling high. Or to build an investment portfolio whose performance beats the S&P 500 average.
If this sounds like the way you'd state your own investment objective, then you, like so many others, may be making The Investment Mistake of the Millennium.
You see, it's not the paper returns that matter. Nor is it the bragging rights you have. The fact that you can boast to your neighbor that you did better than he did means nothing.
You see, what really matters is...how much money actually ends up in your or your family's pocket.
Your neighbor whose investment returns are so much poorer than yours could still end up wealthier, with more spending loot than you.
Say you both put bought ABC stock January 2, 1999, for US$10,000. By December 15, ABC had jumped 50% -- a US$5,000 gain for you. You sell right then and there...nothing like locking in some gains.
Your neighbor waits until January 10 of 2000 to sell. By then, the ABC has given back some of its gains, and is up only 45% since purchase. Who ends up with more in his pocket? The dunce next door.
By selling the stock before 12 months were up, you must pay ordinary tax on that stock. If you're in the 28% tax bracket, you pay a federal income tax of US$1,400. That means you have a net gain of US$3,600.
But your neighbor held the stock for more than one year. That means he gets to apply the long-term capital gains rate of 20%. His tax is US$900. Thus his net gain is US$3,900. Even though the stock went down after you sold, you still have US$300 less in your pocket than the other guy. And that doesn't even take into account the benefit of deferring taxes until the next tax year.
Ten secrets to low investment taxes
You see, by the time you or your family gets to spend any of the investment profits, the government gets to skim off the top. How much it takes, if anything, depends on you and your decisions.
To avoid making the investment mistake of the century, take these 10 steps:
- Make it a habit -- a part of your investment routine -- to take taxes into account with every investment decision you make.
- Before you sell a profitable investment held for less than a year, weigh the benefits of selling versus the bath you'll take by paying ordinary tax rates.
- Don't "day trade" in the sense that you buy and sell furiously every day -- unless you carefully determine the impact of taxes (as well as commissions) on your returns. If you're so good at day trading that you can overcome the IRS' assault on your profits...be my guest.
- Put as many of your investments into retirement plans as you can. Use a 401(k) plan, a Keogh, an IRA...any plan you're entitled to use.
- Put the right kinds of investments into retirement plans. Keep tax-exempt bond funds out of it. Tax-efficient funds and index funds also should be held outside of retirement plans because they don't incur much tax. But stocks and stock funds that you expect to appreciate greatly, that issue dividends, or that you will be trading often, make excellent fodder for retirement plans.
- Make judicious use of losses. Before year-end, examine which depreciated stocks should be sold. Sell those before the end of the year, particularly if you have taxable gains this year. Even if you don't, you can deduct up to US$3,000 in net losses. The remaining losses can be carried over to next year.
- If you buy mutual funds, take into consideration the funds' tax efficiency, and the timing of their tax distributions.
- If you wish to make a donation to charity, and you have appreciated stock...donate your stock to charity. You avoid the capital gains tax, and you get a charitable deduction for the fair market value of the stock on the day you donate it. That's a great combination. Whatever you do, DON'T sell an appreciated stock first and then donate the proceeds.
- You can also make a gift of your appreciated stock to a child. The child will eventually have to pay tax on the appreciation -- his basis is the same as your basis. But at least you don't pay tax on it, and you don't need to sell it now, pay the tax, and gift the proceeds.
Or put investment assets in your child's name. If your child is under 14, investment income up to US$700 can be included on your child's tax return -- at a presumably lower rate. If your child is older than 14, all his or her investment income is taxed at the child's rate.
- Take advantage of the single best investment tax shelter ever created -- Death. At your death, the tax bases in all your investments get stepped up to their fair market value. That means, if your children or spouse sell the stock immediately after your death, they recognize no taxable gain -- even if the profit is 10,000%!
If you don't need the spending dough, hold your best long-term stocks forever -- that is, until you kick off this mortal coil.
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