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Why be a FrugalInvestor?
Guideline
to Frugal
Investing
Choosing
the right
stocks
Stock Recommendations
Tax Strategies
Disclaimer
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Taxes are probably the biggest expense that an investor must pay. That is why a frugal investor needs
to minimizes capital gains taxes reported on a schedule D, and dividend and capital gains
distributions reported on a 1099-DIV. Obviously, the less taxes that are paid, the higher the returns
for the investor. Luckily there are many ways to minimize taxes. There are also tips for preparing taxes
and reporting taxes for investments and capital gains. The tax strategies are listed below.
Maximize Tax Sheltered Retirement Accounts
Invest in Stocks over Mutual Funds
Avoid Short Term Trading
Reporting Taxes on Stocks and Mutual Funds
1.
Maximize Tax Sheltered Retirement Accounts
Traditional IRA's, 401Ks and Roth IRAs are great because any
capital gains, dividends and interest are not taxed until you withdraw
your money. Roth IRAs are potentially better because the Government
has promised that these accounts will not be taxed even when the money is
withdrawn. The advantage of 401Ks and traditional IRAs is that the money contributed
is deducted from that year's taxable income. However, all distributions will be taxed
at the income tax rate when the money is withdrawn. In reality either type of account
will be good places to save. There is debate on which account is better for long term
investors.
Example: Mr. Johnson has a pre-tax amount of $2000 to save in 1980.
In 1980 he put that savings in a traditional IRA. He put the money into S&P stocks with
negligible investment expenses. The traditional IRA has accumulated to $28,000 (The S&P
returned approximately 14 times from Jan 1980 to April 2007). When the $28,000 is withdrawn,
it is taxed as income. So if income taxes are 30%, he
will be left with $19,600.
The next example assumes Mr. Johnson puts money in a Roth IRA. Note Roth IRAs did not exist
in 1980 but it is good for illustrative purposes. The after tax equivalent of saving $2,000
assuming 30% income tax is $1,400 ($2,000*[1-30%]). This after tax income is contributed into a
Roth IRA because there is not a deduction to current income. However, that $1,400 will grow
compounded for many years to $19,600.
It is no coincidence that the returns were exactly the same in both the traditional and Roth IRA.
Assuming the tax rate is the same at the time of withdrawal and the time of contribution either
option will be equally as good.
Of course, if Mr. Johnson had more than $2,000 to save then he could still put as much as $2,000
after tax into the Roth IRA and keep the full $28,000 when the money is withdrawn in 2007.
Tax sheltered retirement accounts are the only place where a
significant portion of bonds and money market accounts should be held because interest is
taxed every year. So if you are earning 5% in taxable account
you are really earning 3.5% which barely beats inflation (this assumes a
combined federal and state tax rate of 30%).
The only caveat to putting money in a retirement account is
that you should plan on holding your money in these accounts until you
reach 59 1/2. Otherwise it is considered an early withdrawal and the penalty
for early withdrawal can be steep. Not only
do you pay taxes on the withdrawal at the marginal income tax rate,
an additional 10% penalty is imposed. The only
exception to avoiding the penalty are qualifying events. These include medical expenses greater
than 7.5% of your AGI, Disability, Death, higher education expenses and first time home costs.
Note that tax laws change frequently and it is important to check with a tax professional before
assuming a qualified event.
2.
Invest in Stocks over Mutual Funds
The advantage of mutual funds is that they are easy to manage and offer
diversification. The taxes, however, can cause
the portfolio to significantly under perform
(see why become a frugal investor
for more illustrations on this point). Individual stocks have
many tax advantages over mutual funds for the following reasons:
Stocks allow you to take full advantage of long term capital gains. By holding stocks
you can determine when to take capital gains. It is best to wait as long as possible to
take capital gains because securities held for one year or more are considered long term
capital gains. Long term capital gains tax rates are federally maxed out at 15%. Short term
capital gains are taxed as ordinary income. You can own stocks as long as necessary and take
the gain when it is convenient. Mutual funds take gains at the discretion of the fund
manager. Thus, mutual funds buy and sell securities generating short and long term capital
gains on an almost daily basis. All short term capital gains and interest must be paid out
as a dividend to shareholders. Some of these capital gains are distributed to the
shareholders and reported in the 1099-Div statement provided by the mutual fund.
Stocks allow flexibility with financial institutions. You can always change brokerage houses
without selling stocks but if you are unhappy with a mutual fund you will be forced to sell and
get taxed immediately on capital any gains. Transferring stocks from one brokerage company to
another just requires a form and it takes are few weeks. Most importantly there is no taxable
event.
Stocks offer an alternative vehicle for deferred income. If a bond pays 10% a year
and a stock rises 10% a year, for the long term investor, it is better to hold on to the stock because
the taxes are not paid yearly. Instead the taxes are paid only when the stock is sold. This allows
compounded growth with deferred taxes and has similar advantages to a traditional IRA with the added
bonus that long term capital gains are only taxed at 15%. More details about this point are discussed
in the section #3.
If you want a mutual fund, make sure it is tax advantaged.
Even though holding stocks for the long term is the best tax advantaged
choice outside of a tax deferred account, there do exist some tax advantaged
mutual funds that have low expenses and minimal capital gains distributions.
ETF's generally fall in this category. Though an ETF will give diversification at low cost -
the ETF will generally buy securities that track some sort of
index. This means that while the investor may have some quality
securities in the portfolio they will undoubtedly hold marginal
securities as well.
3. Avoid Short Term Trading
Short term trading wastes expenses in commissions, bid/ask spread differentials and most of all
has heavily disadvantaged tax consequences. The most notorious short term investors are day traders.
Numerous studies have shown that most day traders lose money. Even if the short
term trader made the same return on their money compared with the
long term investor, the short term investor is still at a great disadvantage due to taxes.
The example below assumes that the day trader is just as profitable as the long term investor.
The tax consequences of short term trading can cause significant underperformance compared with
the long term investor.
This table illustrates the financial advantage of deferred capital gains tax.
If an investor
frequently trades stocks for short term gains less than a year, he will have to pay
tax on those gains. A long term investor will not pay tax until the stock is sold.
For example, investor A and investor B invest in stocks with an average return 10% a year,
and long term and short term capital gains taxes are 30%. Investor A frequently trades
one stock for another and holds them for less than a year. Investor B just buys a few
stocks and holds them for 10 years.
The pre-tax net return for both investors is the same amount of $15,937 or 159% gain ($15,937/$10,000)
Investor A, however, needed to pay 30% tax on his earnings every year leaving an
after tax gain of $9,672. Investor B, waited to sell his stocks after 10 years and his
after tax return is $11,156. The tax outperformance ratio for the long term investor is
1.15 or $11,156/$9,672. Note that the higher the returns and the longer the stocks are
held, the better the tax outperformance. Also note that investor A could have also been
a bond investor because interest income from bonds is also taxed every year. Hypothetically,
If a stock were guaranteed to rise 5% a year and a bond paid 5% interest, it is more tax
advantaged to own the stock.
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This table is the same as the tax outperformance table above except that the long term capital
gains tax is 15% instead of 30%. Notice that the outperformance ratio improves
significantly given the advantage of the lower long term capital gains tax. Note to qualify for
the maximum 15% capital gains tax, the stock must be held for at least a year.
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It is also worth noting that long term investors may get more favorable treatment of stock and mutual
fund dividend distributions. Until 2009, dividends will be taxed at no more than 15%. In order to qualify
the company must be headquartered in the U.S. and the security must be held for at least 60 days prior to
the ex-dividend date. A long term investor is more likely to qualify for the reduced dividend because they
are more likely to meet the requirement of owning the stock 60 days prior to the ex-dividend date.
4. Reporting Taxes on Stocks and Mutual Funds
The tedious task of reporting investment gains can be made a lot simpler by taking some simple
steps. These steps can also help manage a tax strategy to pay the least amount of taxes possible
and maximize gains. The steps for reporting taxes include downloading transaction software into
money management software from the brokerage company, waiting as long as possible to report
all 1099-Div statements, and lastly specify which shares to sell when figuring capital gains on the Schedule D
tax form.
Use Tax Software. If you make a lot of transactions it would help to get a good money management software. Software makes
filling out the schedule D for reported capital gains much easier. It is
often relatively simple to download transaction information from your brokerage company to money
management software. The money management software can then be used to see how much capital gains
you had during the year. Some brokerages download dividends and a quarterly estimated tax payment could
be made based on this information. Another advantage is that tax software will usually import
the information from money management software. Only stick with the most well known money management
software packages. The most well known are shown below.
Don't Rush to file taxes. 1099-Div statements show dividends and distributed capital gains from mutual funds during the year. Brokerage companies
and mutual funds must send 1099-Div statements by Jan 31st of the year following the tax year. However,
they sometimes correct these statements after the Jan 31st deadline has passed. If you take the first 1099-Div that was
mailed to you and quickly file your taxes then there may be a discrepancy between what was reported to the IRS
and the 1099-Div that was reported on your original return. If there is a difference in the 1099-Div, then you may need to
file an amended return. If you chose to ignore it then you will get a notice from the IRS possibly requesting more taxes
and interest. This wastes considerable time and effort so wait until April 15th to file and confirm with the brokerage or
mutual fund company that you have the most current 1099-Div.
Calculate capital gains by specifying the shares to be sold.
With good money management software you could effectively delay paying taxes on capital gains
if you bought the same stock or mutual fund at different times. When you sell a portion of it
you can decide to sell the shares based on FIFO which is effectively selling the first shares
you bought, LIFO which is selling the last shares you bought or lastly you may specify exactly
which shares to sell. It is in your best interest to delay paying taxes to maximize long term
capital gains. Therefore, it is best to always specify which shares to sell. You want to minimize
the gain or maximize the loss. Note that if the total capital loss from all sales for the year
exceeds $3,000 then you cannot deduct that loss from income. Instead, it must be carried forward
to the next year.
For example, if you bought 100 shares of Intel on Jan 1, 2006 at $20/share then buy another 100 shares of
Intel at $25/share in Jan 1, 2007 then in April 30th 2007 you sell 100 shares at $22. How much
capital gains should you report. If you use specify shares, you can match the 100 shares that you
bought on Jan 1, 2007 at $25 with the 100 shares sold on April 30th. You will be able to report
a $300 capital loss which can be deducted from other capital gains. If there are no other capital gains
hen it can be deducted from the adjusted gross income on the 2007 income tax return. The potential tax
on the shares bought on Jan 1, 2006 at $20/share will be delayed until the next Intel share or shares
are sold.
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