Plan Now
to Reduce
Your Taxes in 2001
Mike Schoeffler, President
Street Falcon, Inc.
Do
you want to lighten your tax bill next April 15? There's good
news you can drastically affect your tax bill next year
and from now on. Here's how:
1) Hold out for
a good tax rate You pay less if you can wait for a
year before selling your investments. For example, what if you're
in the 28% bracket? Because of capital gains laws, you'll only
pay 20% tax if you hold the stock for a year. On a $10,000 gain,
this is an extra $800 in your pocket.
But what if you want
to lock in gains on a stock that had a significant increase?
While you can't completely lock in the gain, you can come pretty
close by shorting a similar stock. (Shorting means that you've
borrowed stock in order to sell it on the gamble that you can
buy it back at a lower price.) For example, if you've made money
on Microsoft, you could short Oracle. Since all computer stocks
tend to move together, this is an effective way to maintain your
gains in the short term. Every time that Microsoft moves down,
you lose some money on Microsoft, but make some back
on your bet against Oracle.
2) Sell off the
losers in your portfolio Everyone's got winners and
losers in their portfolio. Selling some for a loss doesn't mean
that you made less money. On the contrary, you wind up with more
money in the end.
Here's why: the government
doesn't care how much money your stocks made or lost until
you sell. If you have one stock that made $10,000 and another
that lost $3,000, you made $7,000 - no matter which one you sell
today. If you sell the first one, you owe money on the $10,000
gain. If you sell the second stock, you can use that loss to
offset other earnings.
This is the silver
lining in the recent poor market performance. Sell off your losers
today! You can take this cash and apply it to new stocks or just
hold on to it for a few months and buy the same stocks that you
had before.
Eventually, you'll
have to pay tax on the winning stock if you sell. But until then,
you can invest it in the market and make even more money. Which
brings us to our third step in reducing your taxes:
3) Never sell your
winners Americans are among the most generous people
in the world. We give lots to charity and even more when we pass
away. But the way that we do it can sharply affect our tax bill.
You don't have to pay
capital gains tax on stock that you give away. So, not only do
you get the deduction for giving to charity, but you avoid paying
tax on all of your winnings. This can be huge. Suppose that you
want to give $10,000 to your local food bank and you have $10,000
of America Online that you bought for $1,000. If you sell the
stock and give cash, you get the $10,000 deduction, but you also
pay $1,800 in capital gains on your $9,000 profit. If you give
the stock, the charity is just as happy, but you hold on to an
extra $1,800.
This even works when
you give money to your kids. While gifts are not tax-deductible,
the capital gains just disappear. The same thing happens when
stocks are passed to your heirs after your death.
4) Avoid stocks with dividends Dividend-paying stocks don't do worse than other stocks, but they're no fun at tax time. Instead of taking your profits years down the line at a low tax rate, dividends force you to take some profit at your regular tax rate and don't let you build up untaxed profits for investing. Even if you reinvest the dividends, you owe taxes on them in the year that the dividends were paid.
5) Keep good records Some portfolio management software records transactions inaccurately. For example, a merger might be tracked as selling the original stock and buying the new stock. As a result, you could look back at this tax-free transaction and think that you owe tax on it even though you never sold anything.
Good records help you in other ways. If you know the tax basis for all of your stocks, it's easy to figure out which to sell first. This can be tricky, especially if you are enrolled in a dividend reinvestment plan. Look for software that will help you track the different lots automatically. And make sure that you can quickly review all of the information about your stocks - you don't want to make the wrong move in the middle of the market day.
6) Invest in individual stocks - A good index fund has low turnover and won't create a lot of taxable transactions. It should be the core of your portfolio. But, you can't use some of the tactics listed above particularly number 2 since all of the stocks are linked together. Therefore, a part of your portfolio should be in individual stocks. Don't be concerned if some of your portfolio goes down in value it's the end result of your entire portfolio that really matters.
Use the six steps above throughout 2001 to lower your tax bill in April 2002. But don't let taxes be the only thing that drives your investing. Taxes are important, but they're just one part of growing your money at the fastest rate possible.
Editor's Note: Mike Schoeffler is President of Street Falcon, Inc., a company that makes portfolio management software, providing investors with an easy way to get unparalleled insight into their stocks and maximum returns from their portfolios.
