Frequently
Asked Questions - Investment Advisory Services
Tax
trap for mutual fund investors.
Mutual
funds generally distribute annual accumulated dividend and capital
gain income during the last two months of the year. Fund owners
receive taxable distributions based on shares owned, regardless
of holding period. For example, if you purchase 1,000 shares of
the General Growth fund on October 1st, subject to a yearend $3/share
dividend, you will receive a taxable distribution for $3,000.
If you wish to make yearend fund investments, consider allocating
purchases to your IRA accounts where dividend distributions are
exempt from current taxation.
What
Makes Mutual Funds Tax Efficient.
Based
on a ten-year study of 330 mutual funds by Chicago fund researcher
Morning Star Inc., the foundation for determining if a fund is
tax efficient has more to do with how much new cash a fund can
attract rather than the fund's investment focus. Fundamentally,
we think of income funds as tax inefficient because distributions
are taxed at ordinary income rates, and capital gain income from
growth funds as tax efficient. Surprisingly, 42 out of the 50
best-performing funds studied, for the last 10 years also ranked
as the most tax efficient funds.
Why?
When a fund receives a flood of new cash during the year it helps
to dilute the fund's year-end distribution--figured on a-per share
basis. This doesn't mean that the fund is any less profitable,
it just means that when it comes time to divvy up the tax bill,
the latecomers are unlucky enough to get a piece of the action.
Which
funds got large injections of cash--- those with the best performance!
The study sorted the 330 funds into five groups, based on how
quickly assets grew over the ten-year period as a result of new
money (as opposed to asset growth from investment gains). The
20% of the funds with the fastest asset growth also had the highest
10-year pre-tax return and the highest tax efficiency. This pattern
was consistent throughout the four remaining groups so that the
bottom 20% of funds in terms of asset growth also had the worst
pretax and worst tax efficiency.
If
you want tax-efficiency, you have to spot those funds that will
garner top-notch results and thus attract new money; while this
is true don't lose sight of the fundamental basis for tax efficiency
mentioned earlier. Consider, for instance, keeping your dividend-oriented
stock and bond funds in your tax-deferred IRA and your growth
funds in a taxable account.
Forfeited
stock.
If
you exercise stock options, file an 83(b) election and subsequently
forfeit the stock, you may not increase your cost basis by the
previously taxed bargain element. In other words the cost basis
is not stepped up to the stock’s fair market value on date
of option exercise. Without an employer repurchase agreement,
your maximum economic loss represents the stock’s acquisition
cost and tax previously paid on the bargain element!
Ten
Rules for Investing in Stocks.
Invest
in what you know. If you don't understand what a company
does, or what industry the company is in, you should avoid buying
stock in that company.
Diversify
your portfolio. Since stocks of companies in the same
industry tend to move together, you should purchase stock in
companies representing at least three different industries.
Set
realistic goals. Don't expect each of your stock purchases
to immediately double in value. Instead, be content if the average
annual rate of return of your portfolio does not lag the return
of the Dow Jones Average, NASDAQ or the S&P 500. Remember,
cash only pays minimal interest in a savings account.
Follow
your investments. At least once a week, you should
check the price at which your stocks are trading. You should
also read the company’s annual and quarterly reports.
Take
advantage of DRIPs. Most companies that pay a dividend
offer dividend Reinvestment Programs. Instead of receiving a
small dividend check each quarter, the dividend is used to purchase
additional shares of the company's stock. Also, most DRIPs allow
additional shares of stock to be purchased directly from the
company; thus avoiding a broker's commission.
Don’t
panic if the stock goes down. If you are confident
that you purchased stock in a well-run company; you should be
willing to hold onto that company's stock, even if it declines
in value.
Don’t
be to eager to sell if the stock goes up. The stock
price of many strong companies continues to rise year after
year. By selling your stock in these companies after they increase
in value by only a few dollars, you may lose out on future appreciation
and only your broker will prosper.
Don’t
be afraid to sell. If, for any reason, you become uncertain
about a company or its industry, sell the stock and don't second-guess
your decision. Hanging on to save your pride usually creates
additional opportunity costs. Also, don't torture yourself by
continuing to follow a stock after it is sold.
Don’t
try to time the market. Buy and hold. Very few people
are able to correctly predict a market rally or a market correction.
By investing in a portfolio of well-managed companies, you should
successfully ride out any market corrections as well as avoid
missing out on any rallies.
Take
advantage of your tax deferred retirement accounts.
Investment activity within your retirement account is not subject
to income taxes until the money is withdrawn from the account.
If possible, stocks purchased as a short-term investment should
be purchased through a retirement account to defer paying taxes
on any short-term gains. (This strategy backfires if the stock
declines in value since losses generally are not tax deductible).
Using
a Put Option to Protect Against Price Drops
In
a more docile market you could protect your investment in a stock
by entering a stop-loss order with your broker. Once the price
drops to that level, your investment advisor will sell the stock.
That may not work in the current market. Many stocks have held
up well until some negative news, a lower earnings projection
for example, comes out. Then the price will drop 10 points almost
immediately. A stop-loss order at just under the current price
probably won't do you any good. For volatile stocks you'll do
better by buying a put. A put allows you to sell the stock at
a certain price. You pay a price for the put, so if the stock
doesn't decline, or doesn't decline by more than the cost of the
put, you'll be out some money. Options are tricky. Check with
your investment advisor.
The
Basics of Cost Basis
As
we enter the fourth quarter, more and more clients call with tax
questions. One of the main topics is cost basis. Why---because
if you sold an investment in 2006, you will need to know your
cost basis and calculating cost basis can be awkward.
Following are answers to commonly asked questions about cost basis:
Q1.
I invested $5,000 in a mutual fund in 1998, and this year I
sold all my shares for $15,000. Do I owe taxes on $10,000?
A1. If you have been reinvesting mutual fund
dividends and capital gains, add them to your original $5,000
purchase price. The total is your cost basis.
Q2.
I transferred the assets in one mutual fund to another fund.
Now I've received a statement saying I sold these shares. I
did not sell anything.
A2. What you did is considered an "exchange",
and it is reportable as a sale. If your investment appreciated,
there is taxable gain regardless of what you did with the proceeds.
Q3.
In 1999, I bought 400 shares of stock at $30. It split 2-for-1
in 2003. After that, I bought another 200 shares at $26. The
stock split again (2-for-1) in 2005. This year, I sold 1,000
shares and am having trouble determining my cost basis.
A3. The 400 shares have split twice and are
now equal to 1,600 shares. To determine their cost basis, divide
the original purchase price by the number of shares they now
represent: $12,000 divided by 1,600 = $7.50 per share. The 200
shares you bought later have become 400 shares. Their cost basis
is $13 per share ($5,200 purchase price divided by 400).
If you did not specify which shares you were selling, you must
use the FIFO (first-in, first-out) method, meaning the shares
you bought first were the ones you sold. Your cost basis is
$7.50 x 1,000 shares or $7,500. If you had planned ahead, you
could have specified that the $13 plus 600 at $7.50, for a total
cost basis of $9,700.
Q4.
I inherited some stock from my grand parent, yet I have no idea
how much they paid for it.
A4. If you inherited the stock upon your grandparent’s
death and did not receive it as a gift, your cost basis is the
value of the stock as stated in their estate documents or the
average of the adjusted high and low stock prices on the date
of death.
The Tax Practice, Inc. is a Registered Investment Advisor licensed by the Securities Exchange Commission; Asset Custodian Fidelity Institutional Brokerage Group. Details of our investment management/planning services and related disclosures are provided in The Tax Practice Inc Form ADV Part I and Part II. Advisory services are offered pursuant to an investment management advisory agreement. Lower fees for comparable services may be available from other sources. Prior investment results may not be indicative of future performance. The Securities Investor Protection Corporation (SIPC) does not protect against a decline in the market value of securities. These statements have not been approved or verified by any governmental authority.
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