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Capital gains without tax pain.

"THE PAIN, THE PAIN." THAT'S HOW DONALD Powells, 40, recalls his experience with the tax code after he left Microsoft, where he had been a technical writer and project manager. "I had accumulated a sizable amount of stock options, which I exercised. The tax bite was hard to take."

Now enjoying early retirement in Christiansted, St. Croix, in the U.S. Virgin Islands, Powells is determined to avoid a repeat of that experience. "Most of my money is invested in municipal bond funds. When it comes to stocks, I buy for the long term and look for mutual funds that have low turnover. I want to keep the IRS out of my life," adds Powells.

But you don't need a store of stock options to worry about taxes putting a dent in your portfolio. If you're an active trader or even a modest mutual fund investor, taxes are likely to gobble up a good chunk of your gains.

For example, suppose you bought 100 shares of Intel stock in early 1996 at $60 per share--a very smart move. By mid-1997, with Intel trading at $150, you took your profits and cleared $15,000 for a $9,000 gain! Not really. If you sold your shares prior to July 29, 1997, after having held them for at lease 12 months, your $9,000 profit is a long-term capital gain, which is taxable up to 20%. Bottom line? You'd owe as much as $1,800 to the IRS, thereby shaving your after-tax gain to $7,200. Not bad, but still nor what you'd projected.

"People with around 560,000 in mutual funds may have to recognize as much as $8,000 in taxable income in a given year," says Percy Bolton, an investment management consultant in Los Angeles who has been recognized by Worth magazine as one of America's best financial advisors. The reason: mutual funds are required to distribute all realized gains to shareholders. Such distributions are taxable, even for investors who didn't enjoy the gains.

So how can you keep your investment portfolio out of the IRS' reach? Here are some savvy strategies:

Time your moves carefully. "If you buy just before a mutual fund's capital gains distribution, you're buying taxable income," says Eardley Willock, tax manager in the New York office of the accounting firm Grant Thornton. Before you buy, check into the fund's capital gains distribution schedule--usually toward year-end--and buy afterwards at a lower price.

Look for low-turnover funds. Some mutual funds trade stocks actively, while others buy for the long term. Those that jump in and out regularly are more likely to generate taxes for their investors. Information on fund turnover is available from sources such as Morningstar Inc. (check your local library for its publications) and from the fund itself upon request. Turnover may vary widely from fund to fund.

For example, consider two popular funds in Morningstar's small-company growth stock category. Baron Asset Fund had a 19% turnover rare last year and distributed only 4 cents per share in taxable gains to its investors. Putnam OTC & Emerging Growth Fund, in contrast, had a 200% turnover rare, completely turning over all its holdings twice last year. Investors in this Putnam fund received over $1 per share in taxable gains in 1996.

Look for tax-efficient funds. Some funds attempt to minimize taxable distributions to investors. They sell losers to offset winners, following accounting practices designed to reduce taxable income. Index funds are often good examples. "I like Schwab 1000," says Powells, referring to a fund designed to track the 1,000 largest publicly-traded U.S. companies. Since its inception in 1991, turnover has been 1%-3% per year, and the fund has yet to make a capital gains distribution.

Buy for the long term. "The more you trade, the more likely you'll incur taxable gains," says Gale P. McEvilley, a financial planner in Charlotte, North Carolina. "If you buy and hold, you'll owe tax on interest and dividends but not as much tax on capital gains."

Along those same lines, don't be too quick to switch from one fund to another, even within the same fund "family." Let's say, for example, you've held Fidelity Magellan for several years and then switch to Fidelity Contrafund. "Fund switching is simple to do and you may never actually receive any money," says Willock. "Most people are not even aware that they're creating a taxable event, but each fund switch must be reported tO the IRS and you'll owe tax on any gains."

If you must take gains, couple them with losses. "You should track your investment activities throughout the year to determine whether you have net gains or net losses," says Joe Haywood, a financial planner with AFP Group in Los Angeles. "If you have net gains, you can sell other securities on which you've lost money. These losses can also offset capital gains distributions from mutual funds." Ideally, you'll wind up the year with a $3,000 net capital loss because that amount can be fully deducted your other income. (If your losses are larger, the excess must be "carried forward" to future years.)

Larry D. Bailey, partner in the national tax services office of Coopers & Lybrand in Washington, D.C., says you should meet with your tax or financial adviser around mid-November each year to get a fairly solid estimate of your capital gains exposure. Suppose this November you calculate that you'll have $5,000 in net capital gains for the year. If you take no action, you might owe $1,270 to the IRS (see sidebar). However, suppose you sell stocks, bonds or mutual funds for an $8,000 loss. Now you have a $3,000 net loss that's fully deductible. This will save you $840-$1,188 in taxes depending on your bracket, instead of a $1,270 tax obligation.

What do you do after you take your losses? You can wait 31 days and buy back the stocks, bonds or funds that you've sold. If you'd rather not wait, you can buy similar but not identical securities right away.

Keep good records. When you sell securities, don't forget to add all reinvested amounts to your "cost basis"; that will reduce the amount of tax you'll owe.

Let's say you invested $10,000 in the Great Growth Fund a few years ago, and you sell your shares this year for $20,000. That's a $10,000 gain, right? Not necessarily. If you've reinvested $2,000 worth of dividends and capital gains distributions over the years, your cost basis is $12,000--not $10,000--so your taxable gain is $8,000 instead of $10,000. If you neglect to make this calculation, you'll wind up paying taxes twice on reinvested distributions.

Good record keeping also comes in handy if you're selling part of a position. For example, you decide to sell $10,000 worth of your $20,000 holding in Great Growth Fund. You can specify exactly which shares you wish to sell by notifying your broker or fund family in writing. Note the date the shares were purchased and the purchase price, then insist on getting a confirmation statement that you asked to sell specific shares. If you specify the highest-cost shares for sale, you'll reduce your tax bill.

Buy individual stocks, particularly if you've amassed several mutual funds. If you buy stocks directly and hold on to them, you won't have to worry about receiving unwelcome capital gains distributions. "Buying stocks directly is not for beginners, but people who know what they're doing can cut their taxes and increase control over their investments," says Willock.

Give away appreciated securities. The holiday season is probably a good time to do so; You'll have a better idea of what your income is and what your tax obligation will be for the year. "Many black people give heavily to charity, especially their churches," says Bolton. "I tell them that if they donate cash on which they've already paid tax, they're giving away expensive money."

Instead, give away stocks or mutual fund shares that have gained in value. "The charity will get full value and you'll get a full write-off, while your capital guns tax obligation disappears," explains Bolton. To implement this strategy, call the charity and get its brokerage account number. Then, call your own broker or your mutual fund company and explain what you want to do, providing the account number. Follow up by fax or phone to confirm the transaction.

For the bonds in your portfolio, use municipal bonds or municipal bond funds. Interest is exempt from federal income tax and, in some places, even state tax. "Municipal bonds make sense if you're in a 28% tax bracket or higher," says McEvilley. That is, if your taxable income is expected to be greater than $25,000 in 1997 ($40,000 on a joint return), you're a candidate for municipal bonds or funds-also known as "munis".

Suppose you can earn 7% in a taxable bond fund. After federal income tax, you'd net 5.04% in a 28% bracket, or 4.83% in a 31% bracket. As such, you're better off earning 5.5% in a tax-exempt bond fund. "Investors in high-tax states such as New York or California may prefer to buy single-state funds to avoid state and local income tax as well," advises Haywood. "Otherwise, the interest from a national municipal bond fund may be subject to state and local income tax." Bolton says that there are also national and single-state tax-exempt money market funds that can provide tax-free interest on cash you're parking for the short-term.

The same principle holds if you buy individual municipal bonds--local bonds may have double or triple tax-exempt status, while out-of-state bonds are subject to state and local income tax. "If you have $25,000 or more to invest and a knowledgeable broker to work with, you might want to look into buying munis directly," says McEvilley. "You avoid paying mutual fund fees, and you'll know that you'll get your money back at maturity."

Be meticulous about paying the tax you owe. "You should receive a 1099 form each year from even bank where you have an account, even, mutual fund you own and so on," says Bailey. "If you don't get them all, ask for the missing ones. You don't want to underreport your investment income and cause the IRS to pay extra attention to your tax return."

RELATED ARTICLE: tax relief or complication?

Depending on your circumstances and income, this year's new tax bill could either be a welcomed relief or leave you in a conundrum.

Figuring the tax on capital gain; has never been easy. You have e to determine which gains arc short-term, where assets are held one year or less and taxable at your regular rate, and which arc long-term and eligible for favorable tax treatment. The new tax law makes this calculation even more complicated.

"Depending on the holding period and the date of sale, some long-term gains in 1997 will be taxed up to 20%, while others will be taxed up to 28%," says Larry D. Bailey, a partner at Coopers & Lybrand in Washington, D. C.

These technicalities also apply to capital gains distributions from mutual funds. "The funds will have to figure out a way to report which gains fall into which category," adds Bailey. "Otherwise, investors will not be able to accurately prepare their tax returns."

For clarification, speak to an accountant specializing in taxes or a tax attorney. You can also check the IRS Web site at www.irs.gov./hot/taxlaw.html.
COPYRIGHT 1997 Earl G. Graves Publishing Co., Inc.
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Title Annotation:Tax Planning; includes a related note on how the new tax relief law of 1997 may effect capital gain taxes
Author:Korn, Donald Jay
Publication:Black Enterprise
Date:Oct 1, 1997
Words:1932
Previous Article:It's a family affair.
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