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Stock and TaxesWe will examine the basic frame work of individual taxation as it relates to investing in stocks and review some of the simple steps you can take to become a more tax-efficient investor. If you are g Ordinary Income Versus Capital Gains Capital gains is the differnce between what you paid for a capital asset and what you eventually sell it for. This income is taxed at a lower rate than ordinary earned income and interest income. Capital gains are subdivided to long-term and short-term. If a stock is sold within one year of purchase, the gain is short term and taxed at the higher ordinary rate. On the other hand, if you hold the stock for more than a year befor selling, the gain is long term and taxed at the lower capitl gains rate. Conversely, you realize a capital loss when you sell the asset for less than you paid for it. You can reduce your tax bill by using capital losses to offset capital gains. Also, to the extent that the capital losses exceed the capital gains, you can deduct your losses against your other income. Any additional loss above the annual limit must be carried over to the next year. Note: due to the IRS's wash and sale rule, you can not claim a loss if you purchase substantially identical 30 days before of after the sale. Tax Advantaged Accounts One easy way to become a more tax efficient stock investor is to utilize the tax advantaged accounts such as 401ks and individual retirement accounts. Tax advantage accounts allow your investments to grow tax deffered or tax free. Tax defferal can lead to significant savings over time. Let's assume to investors each start with $10,000 and earn a 10% annual return for 30 years. One has 100% of her gains tax deffered, whlile the other realizes the full impact of his capital gains each year and pays a 20% tax on those gains. Under this scenario, the tax deffered investor ends up with $75,000 more than the investor with the taxable gains. Clearly it is worthwhile to learn about the types of tax advantaged accounts. To learn more about tax advantage accounts click on this link: www.irs.gov/p590/ . Tax Planning Besides taking advantage of 401k and IRA accounts, you can also follow a few basic planning strategies for investments held in taxable accounts. However should keep in mind that your goal as an investor should be to receive the highest after tax return, not to avoid paying taxes. Taxes are a consideration but they should not control your investment decisions. All things being equal, it is better to pay taxes later than sooner. Thereforer you should endeavor to defer taxation as long as possible. An investor who purchases the shares of sound businesses and patiently holds them will not only enjoy the benefits of tax free compounding, but will also save on brokerage commissions. At the least you should consider delaying the realization of capital gains until January to defer your liability to the next year. If you are extremely patient and die holding a stock, then your beneficiaries will receive the stock on a stepped up basis, or a basis equal to the market value of the stock on the date of your death. Your beneficiaries can then sell the stock and owe no tax on the capital gains accumulated during your lifetime. Wait for Long Term Capital Gain Treatment If you purchase a stock on January 1, 2007, selling it for a gain on December 31, 2007 would not be a smart tax move. In this case your capital gain is short term and taxed at the ordinary income tax rate. Had you sold only a few day later on January 5, 2008, the gain would have been treated long term and taxed at the lower 15% or 5% rate, and in addition would be delayed another year. Take Short Term Losses If you happen to have both short term and long term capital gains, you may want to consider realizing short term capital losses on stocks you have held for less than one year. These short term losses will offset your short term gains, which are taxed at higher ordinary income rates. This will give you the most tax mileage for your capital loss. When faced with large capital gains and losses, it may be to your advantage to realize both in the same year. Suppose you have $30,000 in capital gains and $30,000 in capital losses. If you realize the capital gain in 2007 then you will have to pay the tax on the entire $30,000. If you decide to realize your loss in 2008, you would have no capital gains to offset it, and you could only deduct $3,000 against your other income. The remaining $27,000 would have to be carried over into over years. Instead of delaying the tax benefits of your loss, you could choose to realize both the capital gain and loss in the same year. Since they completely offset each other you would owe no taxes.
The Financial Reality Taxes can have a meaningful impact on your long-term investment performance. Investing in stocks without regard to tax impact can greatly reduce your return. But by understanding the basic framework of investment taxation and using a few simple tax-planning strategies, you can work to maximize the only number that matters in the end: the amount of money that goes into your pocket.
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