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Investing 401: developing a solid tax strategy is critical to making sure your profits don't turn into a loss. (Investing Part 4 Of A Series).

AS INVESTORS WRESTLE WITH THEIR 2001 TAX RETURNS, THEY'LL quickly discover that the odds are stacked in favor of the IRS. Investment gains are fully taxable, while investment losses are deductible only in part: perhaps a small part. Heads the IRS wins, tails you lose.

Fortunately, you don't have to meekly accept this fate. "If you know the rules and you have the right tax strategies, you can offset investment gains with losses and come out ahead," says Mario J. Daniels I, a CPA at Mario J. Daniels & Associates in Flint, Michigan.

Maximizing the profit from winning investments and minimizing the sting of losing stock picks are the keys to maintaining a profitable portfolio. Parts one, two and three of our series on investing were intended to help sharpen your ability to pick winning investments. This final part of the series will help your efforts really pay off. It's what you keep after the investment is sold that ultimately makes the difference. Here are some rules you should know:

Long-term gains are better than short-term gains. If you sell a stock or mutual fund you've held for 12 months or less, any profit will be taxed at your regular tax rate. In 2002, the top federal tax rate is 38.6%. If you hold on to a stock that has increased in value for more than a year before selling, you automatically lower your tax bill. After a year, "any profit will be a long-term capital gain and federal tax will be no more than 20%," says Daniels.

Use trading losses to offset trading gains. One of Daniels' clients is Rob Boyler, president and CEO of International Financial Corp., a Flint company that provides financing for mortgages and capital equipment. "During the bull market," he recalls, "I made some profits on Internet stocks. When I took those profits, I had short-term gains, which would have been highly taxed."

Therefore, Boyler sold some other stocks at a loss. "In fact," says Daniels, "he took losses that exceeded his gains by $10,000 early last year. That gave him a $3,000 tax loss for the year and a $7,000 capital loss to carry forward, as well as cash in his pocket from selling those stocks."

Under the tax law, your capital gains and capital losses are netted each year. Net capital gains are fully taxable, short- or long-term. If you have a net capital loss, up to $3,000 per year can be used as a tax deduction from your ordinary income. Any capital losses beyond $3,000 can be retained for the future, when they can offset net gains.

Harvesting losses can pay off. Some investors match gains and losses at year-end, in an effort to wind up the year with net losses rather than net gains. However, taking losses can be a year-round strategy. "I sold some stocks at a loss during 2001, well before the end of the year," says Dr. Thermutus McKenzie, a physician at Comprehensive Women's Healthcare in Atlanta. McKenzie says that she has been waiting for signs of recovery before moving that money back into the market.

By taking a large paper loss on a stock or a mutual fund right away, an investor can build up a "bank" of tax losses that can be used to offset future gains. In that position, you can take capital gains without worrying about the tax bill.

"When clients have to decide what to sell, I recommend that they sell the losers and keep the winners," says Femi Shore, a financial planner at Asset Harvest Group in Waltham, Massachusetts, who calls the process "harvesting assets." As Shore puts it, "We have developed a strategy to help assure that assets are being harvested in the most effective manner. When done in a taxable account rather than in a tax-deferred retirement plan, this strategy provides immediate tax losses, while deferring taxable gains."

Be mindful of the "wash sale" rules. If you sell a security at a loss, and then buy it back immediately, you can't count the transaction as a capital loss. "You run into the wash sale rules," says Daniels. "I tell clients they have to wait more than 30 days before they buy back the same stock or fund."

An alternative is to buy a comparable security--one in the same sector or industry, but with better prospects for growth. For example, if you sell Ford (NYSE: F) stock at a loss, you might buy General Motors (NYSE' GM) right away without jeopardizing your tax break. "Similarly, you can sell a mutual fund that hasn't done well and buy a similar one," says Osmond Baptist, a financial planner at Members Financial Services in Atlanta. You might sell one growth fund at a loss, and immediately reinvest the proceeds in another better-performing growth fund.


Mutual fund distributions can provide you with unwelcome gains. If you invest outside of a retirement plan and put your money into mutual funds, you'll owe taxes each year on earnings realized by the fund, even if you hold on to your fund shares and reinvest all distributions. "Therefore," says Baptist, "if you're going to sell a fund at a loss, sell before it makes a capital gains distribution. Similarly, try to avoid buying a fund right before a distribution, because you'll get that distribution and owe taxes." Most funds will tell callers when distributions can be expected.

Tax-managed mutual funds call provide shelter. Some funds intentionally avoid realizing gains, or offset any gains by taking losses. On Websites such as, you can find a number of mutual funds with the words "tax-managed" in their titles. "Funds that aren't intentionally tax-managed may be tax-aware," says Baptist. "To minimize taxes, look at a fund's record for the past five years and invest in one that has made minimal distributions of capital gains."

Variable life insurance can provide tax-free, not merely tax-deferred, investment income. Baptist sometimes suggests variable life insurance to selected clients. "There has to be a need for insurance," he says. "If so, variable life can pay off for long-term investors." Policyholders can allocate their premiums among various sub-accounts, many of which are similar to mutual funds.

Sharon Barnwell, co-owner and CEO of Caribbean International Shipping, a freight-consolidation company based in Stone Mountain, Georgia, decided to take Baptist's advice. "My husband, Gordon, and I have a young son so we need the life insurance," she says. "By choosing variable life and investing in the equity sub-accounts, we expect to build up a significant amount of cash value within the policy."

A life insurance policy's cash value is viewed as an investment account: Profits aren't taxed as long as they remain inside the policy. "I'm hoping to retire in about 20 years," says Barnwell. "By then, I plan to tap the cash value of the policy, tax-free." Untaxed policy loans and withdrawals are permitted under current law, if handled carefully.

Ivan Bishop, vice president of product marketing for Pacific Life Insurance Co. in Newport Beach, California, provides the following example: A 45-year-old nonsmoker in good health buys a $500,000 variable life insurance policy and agrees to pay $10,000 per year in premiums. Over the next 20 years, he pays a total of $200,000.

If those premiums are placed into investment accounts that earn 10% per year, before policy expenses when he retires at 65 (a possible outcome), the policy's cash value will be in excess of $400,000.

"Under these assumptions," says Bishop, "he can withdraw about $35,000 from the cash value, tax-free, each year. This can go on for nearly six years, until he has withdrawn $200,000, which is the amount he has paid in premiums."

At that point, he can start to borrow that same $35,000 per year. "This can go on until age 90, with those assumptions," says Bishop, "gradually reducing the policy's death benefit from around $500,000 to less than $200,000. However, under those same assumptions, taking $40,000 or more per year from the policy will cause the policy to lapse and result in a large tax bill, so you need to be careful."


Interest income need not be taxable. You can reduce the taxes you pay on income from bonds as well as from stocks. "Generally, the higher your tax bracket, the more appropriate an investment in tax-exempt municipal bonds will be," says Cheryl Holland, a financial planner at Abacus Planning Group in Columbia, South Carolina.

You might earn 5% from a Treasury bond, for example, and take home only 3.5%, after taxes, assuming a 30% tax bracket in 2002. In that case, you would receive greater after-tax income from a municipal bond yielding 4%. "If you're buying municipal bonds," says Holland, "the longer the time to maturity, the higher the commission to the broker selling the bond. The same may be true for credit ratings. Typically, the lower the quality of the bond, the higher the commission to the selling broker."

With muni bonds, beware of "too much" tax shelter. If you buy out-of-state municipal bonds, you may pay state income taxes, while locally issued bonds are totally tax-free. "However," says Holland, "many investors are leery of owning bonds from another state or municipality. But they find that paying the additional state income tax is worth the reduction in risk you get by having a diversified portfolio of municipal bonds from a variety of states and related entities."

For example, suppose you buy a $25,000 out-of-state municipal bond paying you 4% interest, or $1,000 per year. If your state and local tax rates add up to 5%, you'd owe an additional $50 per year in tax (5% of $1,000) netting you $950.

However, that $50 state tax payment probably would be tax deductible, saving you $15 in a 30% federal tax bracket. So you'd wind up with a net tax cost of $35 ($50 minus $15) and net interest income of $965 instead of $1,000. Is that extra $35 per year, on a $25,000 investment, worth the risk of loading your portfolio with bonds from one area? "Local economic distress may hurt the bonds' ratings and send your bond prices lower," says Holland.

As April 15 approaches, investors need to begin formulating a tax strategy that will help them keep more of their portfolio gains in 2002. What can you do with your losing investments to offset the tax consequences of high-performing investments in your portfolio this year? Should you consider investing in more tax-friendly investment vehicles? Consult a qualified tax professional if you need to, but be sure to use the tax laws to your advantage. It is critical that your retirement funds don't end up enriching Uncle Sam.



The Ernst & Young Tax Saver's Guide 2002 Edited by Peter W. Berstein John Wiley & Sons $16.95)

J.K. Lasser's Online Taxes Edited by Barbara Weltman John Wiley & Sons $16.95

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Author:Korn, Donald Jay
Publication:Black Enterprise
Geographic Code:1USA
Date:Feb 1, 2002
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