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201-Stocks and Taxes
  Course 201:
  Stocks and Taxes
  Unlike death, taxation can at least be minimized. In this lesson, we will
  examine the basic framework of individual taxation in the United States as it
  relates to stock investing and review some simple steps you can take to be a
  more tax-efficient investor.
  
  The information in this lesson is not necessarily exclusive to stock
  investing; much of it is also relevant to mutual fund investing. Nevertheless,
  if you are going to invest in any asset class, including stocks, it is
  imperative to understand exactly how taxes work so you may keep as many
  dollars as possible in your pocket and away from Uncle Sam.
  
  
  Ordinary Income Versus Capital Gains
  Capital gains--the difference between what you sell a stock for versus what
  you paid for it--are "tax preferred," or taxed at lower rates than ordinary
  income. Ordinary income includes items such as wages and interest income.
  
  Capital gains arise when you sell a capital asset, such as a stock, for more
  than its purchase price, or basis. Capital gains are further subdivided into
  short term and long term. If a stock is sold within one year of purchase, the
  gain is short term and is taxed at the higher ordinary income rate. On the
  other hand, if you hold the stock for more than a year before selling, the
  gain is long term and is taxed at the lower capital gains rate.
  
  Conversely, you realize a capital loss when you sell the asset for less than
  its basis. While it's never fun to lose money, you can reduce your tax bill by
  using capital losses to offset capital gains. Also, to the extent that capital
  losses exceed capital gains, you can deduct the losses against your other
  income up to an annual limit of $3,000. Any additional loss above the $3,000
  threshold is carried over to the be used in subsequent years. (Note that due
  to the IRS' wash-sale rule, you cannot claim a loss if you purchase
  substantially identical securities 30 days before or after the sale.)
  
  
  Jobs & Growth Tax Relief Reconciliation Act of 2003
  Among other things, the 2003 tax cut (known affectionately as JGTRRA) lowered
  the tax rate for both long-term capital gains and qualified dividends to 15%
  for most taxpayers, and to 5% for taxpayers whose income places them in the
  10% or 15% income tax brackets.
  
  Since the basic idea behind the dividend tax cut was to reduce the burden of
  "double taxation," or taxation of the same profits at both the corporate and
  shareholder level, any dividends paid out of profits not subject to corporate
  taxation will not be considered "qualified dividends" eligible for the reduced
  tax rate. Therefore, one notable exception is dividends from real estate
  investment trusts, or REITs, which are typically still taxed at ordinary
  income rates. In addition, to qualify for the reduced dividend tax rate, you
  must have held a stock for at least 60 days out of the 120-day period
  beginning 60 days before the ex-dividend date (the date on which you must be
  holding a stock to receive the dividend).
  
  Unless the provisions of the 2003 tax cut are extended, the lower rates for
  long-term capital gains and qualified dividends will expire in 2009. In that
  year, the old 20% and 10% rates for capital gains will return, and all
  dividends will again be taxed at ordinary income rates. However, in 2008, the
  special 5% tax rate for lower-income taxpayers will drop to 0%.
  
  
  Tax-Advantaged Accounts
  One easy way to become a more tax-efficient stock investor is to utilize
  tax-advantaged accounts such as 401(k)s and individual retirement accounts
  (IRAs). These special accounts allow you to enjoy either tax-deferred or
  tax-free growth of your investments.
  
  Tax deferral can lead to significant savings over time. Let's assume two
  investors each start with $10,000 and earn a 10% annual return for 30 years.
  One has 100% of her gains tax-deferred, while the other realizes the full
  amount of his capital gains each year and pays a 20% tax on those gains. Under
  this scenario, the tax-deferred investor ends up with almost $75,000 more at
  the end than the investor with the taxable gains.
  
  Clearly, it is worthwhile to learn about the types of tax-advantaged accounts
  available. Below are some of the most popular:
  
  401(k)s
  401(k) plans, so named after a section of the Internal Revenue Code, are set
  up by employers as a retirement-savings vehicle. The primary advantage of a
  401(k) is tax deferral. First, employees can contribute a percentage of their
  income from each paycheck to their own 401(k) accounts on a pretax basis. This
  means the amount you contribute to your 401(k) is exempt from current federal
  income tax. For example, if you are in the 25% income tax bracket, a $100
  contribution will reduce your current tax burden by $25. Second, dividends and
  capital gains earned inside a 401(k) are not subject to current taxation. In
  short, 401(k) plans allow you to defer taxation on dividends, capital gains,
  and a portion of your wages until you begin withdrawing from the plan,
  presumably during retirement, when you may be in a lower tax bracket. (All
  withdrawals are taxed at ordinary income rates.)
  
  The amount you can contribute to your 401(k) plan is limited to $14,000 in
  2005 and $15,000 in 2006. Thereafter, the annual contribution limit can be
  adjusted in $500 increments to account for inflation. You also must begin
  mandatory withdrawals from your 401(k) when you reach age 70 1/2. Withdrawals
  made before you turn 59 1/2 are taxed as ordinary income, and you may be
  subject to an additional 10% penalty.
  
  Traditional IRAs
  Individual retirement accounts are another vehicle for tax deferral. When you
  contribute to a traditional IRA, the IRS allows you to take an income tax
  deduction up to the amount of the contribution, subject to income limitations.
  In addition, dividends and capital gains earned inside a traditional IRA are
  not subject to tax until withdrawal.
  
  However, there are some important limitations to remember. First, you must be
  age 70 1/2 or under with earned income to contribute to a traditional IRA.
  Second, the annual contribution limit is $4,000 from 2005 to 2007. The limit
  rises to $5,000 in 2008, and thereafter can be adjusted in $500 increments to
  account for inflation. If you are age 50 or older, you can make additional
  "catch-up" contributions of $500 in 2005 and $1,000 from 2006 onward. Finally,
  like 401(k) plans, you must begin mandatory withdrawals when you reach age 70
  1/2. Withdrawals made before you turn 59 1/2 are taxed and may be subject to
  an additional 10% penalty.
  
  Roth IRAs
  These are typically the best retirement account option for many taxpayers. As
  with traditional IRAs, interest income, dividends, and capital gains
  accumulate tax-free. However, the main feature of Roth IRAs is that they are
  funded with aftertax dollars (contributions are not tax deductible). The
  upside of this is that qualified distributions from a Roth IRA are exempt from
  federal taxation.
  
  The Roth IRA has the same annual contribution limits and "catch-up" provisions
  as a traditional IRA, but you must meet certain income requirements to
  contribute to a Roth IRA. Generally, single filers with income up to $95,000
  and joint filers with income up to $150,000 are eligible to make the full
  annual contribution to a Roth IRA. Contributions to a Roth IRA can be
  withdrawn at any time without paying taxes or penalties, but withdrawal of
  earnings may be subject to income taxation and a 10% early withdrawal penalty
  if made before you turn 59 1/2.
  
  In addition, the distribution must also be made after a five-tax-year period
  from the time a conversion or contribution is first made into any Roth IRA.
  So, if you open your first Roth IRA and make your first contribution on April
  15, 2005, for the 2004 tax year, your five-year period starts on Jan. 1, 2004.
  Assuming you meet the other requirements, distributions made in this case
  after Dec. 31, 2008, from any Roth IRA will receive tax-free treatment.
  
  
  Tax Planning 101
  Besides taking advantage of 401(k) and IRA accounts, you can also follow a few
  basic planning strategies for investments held in taxable accounts. However,
  you should keep in mind that your goal as an investor should be to achieve the
  highest aftertax rate of return, not to avoid paying taxes. Taxes are a
  consideration, but they should not control your investment decisions.
  
  The Value of Deferral and Stepped-Up Basis
  All things being equal, it is better to pay taxes later than sooner.
  Therefore, you should endeavor to defer taxation as long as possible. An
  investor who purchases the shares of sound businesses and patiently holds them
  will not only enjoy the benefits of tax-free compounding, but will also save
  on brokerage commissions. At the least, toward the end of the year, you should
  consider delaying the realization of capital gains until January to defer your
  tax liability until the following year.
  
  If you are extremely patient and die still owning a stock, your beneficiaries
  will receive the stock with a "stepped-up" basis, or a basis equal to the
  market value on the date of your death. Your beneficiaries can then sell the
  stock and owe no tax on the capital gains accumulated during your lifetime.
  There are special limitations on basis step-up if you happen to die in 2010,
  but after that year, the rule returns in its current form.
  
  Wait for Long-Term Capital Gain Treatment
  If you purchased a stock on Jan. 1, 2005, selling it for a gain on Dec. 31,
  2005, is likely not to be a smart tax move. In this case, your capital gain is
  short term and taxed at ordinary income rates. Had you sold the same stock a
  few days later on Jan. 2, 2006, the gain would have been treated as long term
  and taxed at the lower 15% or 5% rate, and in addition would be delayed
  another year.
  
  Take Short-Term Losses
  If you happen to have both short-term and long-term capital gains, you may
  want to consider realizing short-term capital losses on stocks you have held
  for less than one year. These short-term losses will offset your short-term
  gains, which are taxed at higher ordinary income rates. This will give you the
  most tax mileage for your capital loss.
  
  Timing Capital Gains and Losses
  When faced with large capital gains and losses, it may be advantageous for you
  to realize both in the same year. Suppose you have $30,000 of capital gains
  and $30,000 of capital losses. If you realize the gain in 2005, you will have
  to pay tax on the entire $30,000. If you decide to realize your loss in 2006,
  you'd have no capital gains to offset it, and you could only deduct $3,000
  against your other income. The remaining $27,000 loss must be carried over
  into future years. Instead of delaying the tax benefits of your loss, you
  could choose to realize both the capital gain and loss in the same year. Since
  they completely offset each other, you would not owe any taxes. On the other
  hand, if you do not have a large capital loss to offset, you should generally
  time the realization of long-term capital gains--which will be taxed at
  favorable rates--for years when you do not realize any capital losses. Then
  you can realize your future capital losses in years when you can immediately
  deduct them against other income that may be taxed at higher ordinary income
  rates.
  
  
  The Bottom Line
  As you can see, taxes can have a meaningful impact on your long-term
  investment performance. Investing in stocks without regard to the tax impact
  can greatly reduce your return. But by understanding the basic framework of
  investment taxation and using a few simple tax-planning strategies, you can
  work to maximize the only number that matters in the end: the amount of money
  that goes into your pocket.