Making Tax-Smart Trades

The sad truth of the investing world is that Uncle Sam can put quite a drag on your investing returns. Nothing is certain but death and taxes, as Ben Franklin said. But by being aware of the tax rules and taking a few simple steps, you can minimize taxes and enhance returns.

The first thing you should do is consider maximizing your use of tax-shielded 401(k) and IRA accounts. For those with 401(k)s, the maximum annual contribution increased to $15,000 with the start of the new year, while those over age 50 can make an extra $5,000 "catch-up" contribution in 2006. Both the figures are up by $1,000 from 2005.

On the IRA side, many taxpayers may also be able to contribute up to $4,000 to an IRA for 2005, $4,500 if you are over 50. The good news is, unlike 401(k)s, you have until April to contribute to your IRAs for the 2005 tax year.

Do keep in mind the downside to IRAs is that there are income thresholds that may limit eligibility and deductibility of contributions. The rules and breakpoints are far too complex to describe here. (Complex tax rules? Shocking, I know.) But the benefits you get from shielding your stocks from the taxman make the effort of learning more worthwhile.

Taxes and Trading
When formulating your tax strategy when it comes to trading stocks, it is worthwhile to remember that there's a difference in tax rates between short-term and long-term capital gains. For stocks held less than one year before sale, the short-term capital gains rate is your ordinary income tax rate, which currently goes up to 35%. However, those who hold their stocks for more than a year and sell at a profit are eligible for the lower long-term capital gains rate, currently 15% for most investors.

Given the difference in tax rates, very rarely is it a good idea to sell for a gain a stock you've held for, say, 360 days. By waiting a few more days to sell, you could dramatically lower your tax bill by becoming eligible for the lower long-term capital gains rate.

And while it is never fun to lose money in stocks, it does occasionally happen to the best of us. No investor has ever batted a thousand. (For instance, both the Tortoise and Hare portfolios I manage in the Morningstar StockInvestor newsletter have easily beaten the market since inception, even though we totally whiffed on our purchases of  Time Warner  and  Merck (MRK).) The silver lining: 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 loss against your other income up to an annual limit of $3,000, with any loss above this threshold carried over to be used in subsequent years.

Before taking advantage of a capital loss, it is important that you keep the wash-sale rule in mind. The rule states that you cannot claim a loss if you purchase substantially identical securities 30 days before or after the sale of the stock. For example, if you sold a stock for a loss on Dec. 28 but repurchased the same stock on Jan. 20, the wash-sale rule prevents you from claiming the loss on your taxes.

Finally, all else equal, it is better to pay taxes later than sooner. A dollar today is worth more than a dollar tomorrow. And in reverse, paying a dollar in taxes tomorrow will cost you less than paying a dollar today. Keep this in mind before selling any stock for a gain, especially if it is the end of the year when waiting until January would defer the tax liability another year.

Even with all this talk about taxes, 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. Sometimes it makes sense to bite the bullet and sell a stock, even if you have to pay the short-term capital gains rate. Considering taxes with every trade is a good idea, but taxes should not solely control your investment decisions.