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“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 least 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 not what you’d projected.
“People with around $60,000 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 rate last year and distributed only 4 cents per share in taxable gains to its investors. Putnam OTC & Emerging Growth