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Strategies for Tax-Smart Investing If you want to boost your investment returns but are wary since the dot-com crash, consider investing with an eye towards your taxes. Tax-smart investing can net you big increases in your gains, and help you make the most of your losses. Here are ten ways you can maximize your gains, while minimizing your taxes.

  1. Hold Stocks for the Long Term
    When you sell stocks for a profit, you have to pay some taxes on the gain. How long you hold on to your stocks, though, makes a difference in the amount of taxes you pay on the sale.
    • If you hold your stocks for 12 months or less, you pay your normal income tax rates on your gains. This could be as high as 38.6% under the new tax laws.
    • If you hold your stocks for longer than 12 months, on the other hand, you pay only 20% on those gains. This could even reduce to 10% and maybe 8% if you are in the 15% tax bracket.
    Example: If you were in the highest tax bracket and bought shares of stock for $10, then sold them for $15 (a 50% gain):
    • If you sold the stock less than 12 months after you bought it, your take-home would be just over 30%, after taxes.
    • If you held those shares for over 12 months before selling them, your return would be 40% after taxes.

    The rates get better the longer you hold the stock. Starting January 1, 2001, if you buy shares and own them for more than five years before you sell them, the tax on your gains will max out at 18%. Even better, if you are in the 15% tax bracket, any gains on stock you sell now are taxed at only 8% (instead of 10%) if you owned the stock for more than five years.

    Most folks on salary do not have much choice on when they get paid, but if you are one of the lucky ones in line for a year-end bonus, consider asking your employer to give it to you in January. Some companies will be able to help you out, but because of stringent rules, others cannot. If you have consulting income, you might want to delay billing so that you will get paid next year.

  2. Max out your Tax-Favored Accounts
    Take advantage of the long-term benefits of investing in tax-free or tax-deferred accounts like 401(k) plans and IRAs, because you do not pay taxes every year on the gains from these accounts, they compound at a much higher rate, which puts you in a much better position at retirement.

    Plus, in 2004, you can put away as much as $13,000 in a 401(K) if your plan permits and $3,000 in an IRA.

  3. Sell Losers for a Tax Gain
    When your stocks go down, you do not have to hold onto them for fear of selling them and losing a lot of money. You can save quite a bit in taxes by selling at a loss.

    Example:
    You have 100 shares of stock that cost $10 a share. You sell it at $5 a share, which means that you can erase $500 from any capital gains. If you end up with more losses than gains, you can deduct up to $3,000 a year from your normal income. If you still have losses left after the $3,000 deduction, you can carry them forward to the following year. Advanced Tip: When you erase gains with your losses, you need to erase similar gains first. For example, you must use long-term losses against long-term gains first, against short-term gains next, and against normal income last. Your best bet is to sell long-term losses in years when you do not have many long-term gains, because long-term gains are taxed at up to 20% and short-term gains are taxed at up to 38.6%, leveraging your long-term losses against short-term gains saves money.

  4. Avoid the Wash Sale Rule
    The biggest risk of selling losses for a tax gain is the Wash Sale Rule. Basically, this rule says that you cannot buy a "substantially similar" security back within 30 days before or after you make the sale. If you do, it negates the loss.

    If you mistakenly succumb to the wash sale rule, though, do not fret. The loss is added to the cost of the new stock to form your new basis (the value you will compare with the price you sell the stock at, to determine whether or not you have gained or lost). So you will get a tax advantage when you eventually sell again. You just have to be patient.

    There are two ways to get around the wash sale rule.

    Be careful and buy the security back 31 days before or after you sell.

    Buy similar, but not substantially similar securities at the same time you sell. This can be particularly easy with mutual funds, where there are many funds that invest in similar securities. There is no rule that says you cannot sell one growth fund for a loss, then buy a similar growth fund from a different company with the proceeds.

  5. Be Specific About your Shares
    When you purchase the same company's stock at different times, you have what's known as multiple "lots" of stock. Each of these lots has a different basis price (cost of the stocks plus any fees you paid the broker for the transaction), as well as different purchase dates.

    While the IRS allows you to account for these lots in a number of ways, brokerages, especially Internet brokerages, tend to use the First In, First Out, or FIFO approach. While using FIFO might make your broker's life easy, if can make your tax bill much higher than it needs to be.

    Here's why. With FIFO, your brokerage sells your oldest shares first, which usually means the lowest-priced shares. This can result in a higher tax bill because you tend to have the largest gains on these older shares. If you use the specific shares method, you can decide which shares to sell for every trade to keep your taxes to a minimum.

    One caveat: Using the specific shares method takes a lot of record-keeping, which means that you will probably want to use a personal finance tool like Quicken to keep track of all your lots. In addition, you should talk to your brokerage about how to inform them about which shares to sell. Often, they require some written directions.

  6. Do not Buy Mutual Funds at the End of the Year
    Unlike stocks, mutual funds must distribute all of their capital gains and dividends to their shareholders at least once a year. Usually, funds do this near the end of the year. If you buy into a fund right before the distribution date, you have to pay taxes on those distributions without enjoying any of the benefits of that year's gains.

    If, on the other hand, you own a fund and you have been thinking about selling it, it might be a good idea to sell the fund before those distributions.

    Either way, funds usually announce the distribution before making it, giving you time to decide.

  7. Buy Tax-Smart Funds
    From a tax perspective, stocks are usually a better option than mutual funds because you do not have to pay taxes on any capital gains until you sell.

    Mutual funds, on the other hand, distribute gains every year. So you face capital gains taxes every year.

    You can get the benefits of a fund (professional management and diversification) and keep capital gains taxes to a minimum by investing in tax-managed funds where managers take the necessary steps throughout the year to minimize capital gains distributions.

    Tip: Index funds tend to have very low distributions because they do not change their holdings very often.

  8. Buy Bonds
    Generally, municipal bonds are free of federal taxes, which means that a municipal bond with a 6% interest rate is really comparable to a taxable bond paying 8%.

    People who live in high-tax states such as California and New York can get an extra boost by buying locally. In such states, an in-state municipal bond paying 6% is actually equivalent to a 9% taxable bond after you account for federal and state taxes.

  9. Transfer your Assets Now or Later
    If you have children between the ages of 14 and 18, you can take advantage of their lower tax brackets by transferring your appreciated assets to them. You and your spouse can each give up to $11,000 a year in cash or assets to each of your children. Eventually, when the assets are sold, they are taxed at your child's lower tax rate.

    Be careful, though. After you transfer an asset to your children, it belongs to them. Also, colleges take into account your children's assets when they consider financial aid applications, which means that you could be jeopardizing your opportunities for financial aid. Make sure to consult a tax advisor before transferring assets.

    If you are nearing an age where you are thinking about your estate, holding on to long-held securities rather than selling them makes sense as an estate-planning tool. If, for example you bought Microsoft shares when it first went public, your shares would be worth a lot of money, but you would pay a huge amount in taxes if you sold them. If your heirs inherit those shares as part of your estate, the basis of the stock immediately increases to today's purchase price. All those gains disappear, meaning you can pass on a lot more.

  10. Donate Appreciated Securities
    When a stock grows in value, we say it has appreciated, and we certainly appreciate that, but if we sell an appreciated security, we face taxes on the capital gain. To avoid paying those taxes, donate the securities to a charity.

    When you donate appreciated securities instead of cash, you take a charitable deduction for the market value of the securities, and you pass on the gains to the charity, which can sell the stock without paying any tax on the gains.

OTP SIG3