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How to secure your investment success: don't let the tax man dip too deeply into your investment earnings for last year or this one. Here's how to protect them.

BYRON KELLY, A FAMILY PHYSICIAN IN Atlanta, had been on an investing spree since 1991, when he checked his finances and found little savings and large debts from medical school. "I decided I could do without the big Mercedes and the vacation in Cancun," he says. Instead, he put his money into a mix of stock funds, building up a portfolio of over $50,000 since then.

For Kelly, like most investors, 1995 was a very good year. In fact, for most investors, 1995 was a gala event, with stocks soaring to record levels and bonds posting sizable gains as well.

However, as everyone knows, after the party's over, the bills come due. If you haven't yet prepared your 1995 tax return, brace yourself: you're likely to find that you owe the IRS more than you bargained for. That's true even if you reinvested your gains and never actually took profits out. You still have to find the money for the taxman's share.

But don't panic. There are still legitimate moves you can make to save on your 1995 tax bill. What's more, while you're focusing on taxes and investments, this is an excellent time to plan ahead so your 1996 taxes won't be as painful.


Here's what you can do now to trim your 1995 tax tab:

* Invest in an IRA. If you worked last year, you're probably eligible to have an individual retirement account (IRA). You can contribute up to $2,000 per year; contributions to a 1995 IRA can be made until April 15, 1996. You can then deduct that contribution from 1995 income if neither you nor your spouse is covered by an employer's retirement plan such as a 401(k). Even if you are covered, you're entitled to some deductions if your income is under $35,000, or under $50,000 on a joint return.

* Start a SEP. If you have self-employment income, you can set up a simplified employee pension (SEP) and take deductions for 1995. "You can contribute about 13% of your self-employment earnings, up to around $20,000," says John Harper, partner in the accounting firm Dunbar, Cook & Shepard in Indianapolis. SEP contributions for 1995 can be made until the due date of your return, including extensions. As the "simplified" in the name suggests, SEPs are meant to be light on paperwork.

For both IRAs and SEPs, your contributions don't need to sit in a low-yield bank account. You can invest that money in stocks, bonds or mutual funds for greater long-term growth potential.

* Get a grip on your gains. If you sold securities (or any other assets) at a profit last year, check the holding period. Short-term gains are taxed at your regular tax rate, which might be 31%, 36%, even 39.6%. But assets held more than one year qualify for long-term capital gains, treatment: the IRS won't take more than 28%.

* Remember reinvestments. When you sell stocks or mutual funds, you subtract your "basis" (cost for tax purposes) from the selling price to find the taxable gain. When you're calculating basis on securities sold last year, don't forget to add in reinvested dividends and capital gains distributions.

Suppose you invested $5,000 in a technology-oriented mutual fund in 1990 and held on to the shares, reinvesting all distributions. Last year, when you thought tech stocks had peaked, you moved all your money from that fund into a health care fund. Your total proceeds from the tech fund were $20,000, so it seems like you had a $15,000 gain.

However, upon checking your records, you discover that you had reinvested $4,000 worth of distributions in that fund. Now, your basis increases to $9,000 and your taxable gain actually falls to $11,000. "This is a very common error," says Harper. "I've seen cases where what looked like a $5,000 profit became a $1,000 taxable gain."

* Figure fund gains carefully. If you have been investing in a mutual fund for years, putting money in at various times and reinvesting distributions, calculating taxable gains may be difficult. Say you built up a total portfolio of 2,000 shares in a fund. Last year, you sold 500 shares in order to rearrange your portfolio. Which 500 shares did you sell?

You could use the first-in, first-out (FIFO) method, which assumes you sold the first 500 shares you bought. However, those likeliest were the least expensive shares--selling them will produce the highest tax bill.

"Instead, you can use an averaging method," says Duane G. Kelley, tax manager in the accounting firm Schulse Hartwig Richter, Houston. "If your shares have been appreciating over time, this probably will reduce your taxable gain. If you choose to average, you must do so the first time you report gains from a particular fund, and you must maintain that method for all future gains or losses from that fund." Calculate gains on fund shares using both FIFO and averaging methods to see which you should use when you prepare your tax return.

(For individual stocks, you must use FIFO. An even better method is to specifically identify shares of stocks or mutual funds at the time of sale to minimize taxes, but it's too late to use this technique for 1995 gains.)

* Expand your expenses. Investment-related expenses are included under "miscellaneous itemized deductions." Your total miscellaneous itemized deductions are deductible to the extent they are over 2% of your adjusted gross income (AGI).

Suppose, for example, that your AGI for 1995 is $50,000. You spent $1,000 on tax preparation and unreimbursed business use of your car, which are also miscellaneous items. Therefore, you're at the 2% threshold. Your investment-related expenses will be fully deductible.

Such expenses might include phone calls to your broker and mail or overnight express charges. Aggressive taxpayers might want to deduct investment-related travel and entertainment, such as a trip to make sure your rental condo is in good repair.

"Some of these deductions may be challenged," warns Kelley. "There are no strict guidelines but, as a rule, the greater your investment activities, the more deductions you'll be allowed." No matter how much you invest, you'll be much more likely to sustain your deductions if you keep a careful log of your expenses.

One investor paying a lot of attention to such deductions these days is Byron Kelly. Because he reinvests all of his fund distributions, Kelly faces a hefty tax bill when he files his tax return this year. To cut his taxes, he'll try to maximize his investment-related expenses, such as the fee he paid his financial planner and the cost of investment-related research on his personal computer. He also plans to ask his tax preparer about deducting the cost of getting investment advice from publications--such as his long-time subscription to BLACK ENTERPRISE!

* Increase investment interest deductions. Borrowing against your stocks or mutual funds to buy more stocks or mutual funds paid off last year: You could have borrowed at 9% and made 30% or more in the market.

This strategy is even better if you can deduct the interest you pay on a margin account. But investment-related interest is deductible only against investment income. Thus, if you paid $5,000 worth of investment interest in 1995 and received only $3,500 in taxable interest and dividends, only $3,500 of your investment interest will be deductible. The excess $1,500 will be "carried forward" to future tax returns for a possible deduction.

There is another way, though. If you're short on dividends or interest income, you can include capital gains as investment income, for the purpose of increasing interest deductions. In the above example, if you had $2,000 in net long-term capital gains in 1995, those gains could "soak up" the excess $1,500, allowing you to deduct all of your investment interest.

To use capital gains in this manner, you have to make an election on your tax return, which has a catch: The gains that offset investment interest lose their favorable tax treatment. They might be taxed as much as 39.6%, while they'd be taxed no higher than 28% if you had not made this election.

What's the best answer? "There's no way to know without doing the math," says Roger W. Lusby, III, of the accounting firm Frazier & Deeter in Atlanta. "But you're usually better off taking your deductions immediately rather than waiting until a future year."


While you're working at paring your 1995 tax bill, here are some strategies for making your 1996 investments less taxing:

* Keep an eye on Congress. As of this writing, the politicians were still debating a tax bill. If a law is enacted that reduces taxes on capital gains, you might be more willing to take profits.

* Contribute to a retirement plan. You should make the most of a 401(k) or similar salary-reduction plan. That strategy has paid off for Wil Bryant Jr., a medical sales representative with Baxter Healthcare in Los Angeles who's pursuing an M.B.A. at the University of Southern California.

"For the past five years, I've been investing in my 401(k)," he says, "while my wife, Gail, who's a teacher, has been contributing to a tax-sheltered annuity with similar benefits. Because so much of our investing is inside these plans, our tax bill from investments is relatively low." Bryant (whose deductions just increased with the birth of a second child) says that such tax-sheltered investing has enabled his family to build a portfolio in excess of $60,000 in five years, as well as a substantial amount of home equity.

Business owners can sponsor a profit-sharing or defined-benefit plan. "In recent years, tremendous flexibility has been added to retirement plans," says Arthur Kraus, chairman of AFP Group, a financial planning firm in Los Angeles. "Now, you can have a plan that's weighted heavily towards your own account."

With 401(k)s, profit-sharing plans, etc., contributions are fully deductible so they'll lower your tax bill right away. Money contributed to such a plan compounds, tax-free, until you take it out, which might be many years from now.

If you have money inside a retirement plan as well as outside, you should arrange your overall portfolio for the greatest tax advantages. "Bond funds and dividend-paying stock funds should go inside the plan," says Kraus, "where the current income will be sheltered. However, if you own stocks or stock funds that don't pay dividends and you don't take trading gains, you should hold those stocks and funds outside the plan. They don't generate much income tax anyway, so why waste the tax shelter?"

If you hold growth stocks or funds inside a retirement plan, any appreciation will be fully taxed, up to 39.6%, when you take withdrawals. Outside of a plan, long-term gains will be taxed no higher than 28%.

* Give away your gains. Do you make contributions to a school, religious organization or some other favored cause? If so, give away appreciated securities rather than cash.

Say you invested $1,000 in a stock many years ago and that stock now is valued at $10,000. If you sold, you'd have a $9,000 taxable gain. Counting state as well as federal income tax, you might owe $3,000 (30%). Thus, that stock really is worth only $7,000 to you.

Therefore, when it's time to fulfill the $10,000 pledge you made to your alma mater, give away the stock. You'll get a $10,000 charitable deduction for giving away an asset that's worth $7,000 to you, and the school can sell the stock without paying tax.

"I've used this strategy personally and it's not difficult to implement," says Lusby. "First, you call the charity and find out their brokerage account number. Then you call your own broker or your mutual fund company and explain what you want to do, providing the account number. Follow up by fax and mail to formalize the transaction."

If your investing last year produced a bloated tax bill, reconsider your strategy. Those taxes may result from excessive trading. Most successful investors hold on and let their profits run. By not taking gains, you're likely to maximize your profits while you minimize your taxes.
COPYRIGHT 1996 Earl G. Graves Publishing Co., Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1996, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Korn, Donald J.
Publication:Black Enterprise
Article Type:Cover Story
Date:Apr 1, 1996
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