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Steve Bauer

Steve Bauer

This is a Course called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant /…

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Investment Basics - Course 201 - Stocks and Taxes

This is the nineth Course in a series of 38 called "Investment Basics" - created by Professor Steven Bauer, a retired university professor and still active asset manager and consultant / mentor.


Course 201 - Stocks and Taxes


Unlike death, taxation can at least be minimized. In this Course, 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 Course 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.

Prof's. Guidance: I apologize to those of you who are not US taxpayers. This Course was written for my Clientele while in practice in California. I do think that the tax laws of other countries are in many ways similar -- but please check with your tax accountant for applicable or similar laws.

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 again, the lower rates for long-term capital gains and qualified dividends will expire in 2011. 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 dropped to 0%.

Prof's. Guidance: Though knowledgeable, I regret that I am not a qualified tax advisor. I strongly urge you to have a short visit with your tax preparer, CPA or other tax qualified person, before investing you money in securities. Most all have some tax consequence.

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) 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 $15,500 in 2008. 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 $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 $1,000 in 2008 and thereafter these "catch-up" contributions will be indexed for inflation as well. 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.

Prof's. Guidance: I would like to try to stimulate your asking me about the following statement - that is - if you don't smile and understand: I advise you, as your number one goal, to - want to pay the highest taxes possible from your investment program each and every year! Giving you a partial answer: the higher your taxes, the more money you must have made!

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.

Quiz 201
There is only one correct answer to each question.

  1. Unless the provisions of the 2003 tax cut are extended again, the lowered 15% and 10% tax rates for long-term capital gains and qualified dividends will expire in which year?
    1. 2011.
    2. 2018.
    3. The 15% and 10% tax rates are permanent.
  1. Which type of tax-advantaged account offers the potential for tax-exempt distributions?
    1. 401(k) account.
    2. A traditional IRA.
    3. A Roth IRA.
  1. All other things being equal, which would you rather own in a taxable account?
    1. Bonds.
    2. The stock of a solid business that grows steadily over time but pays no dividend.
    3. A high-yielding utility stock.
  1. You must generally begin making mandatory withdrawals from 401(k) and traditional IRA accounts when you reach what age?
    1. 70 1/2.
    2. 59 1/2.
    3. 65.
  1. When does your five-taxable-year period for Roth IRAs start?
    1. On Jan. 1 of the tax year when you make your first contribution or conversion to a Roth IRA.
    2. On the date of your first contribution or conversion into a Roth IRA.
    3. On the date of your first withdrawal from a Roth IRA.

Thanks for attending class this week - and - don't put off doing some extra homework (using Google - for information and answers to your questions) and perhaps sharing with the Prof. your questions and concerns.


Investment Basics (a 38 Week - Comprehensive Course)
By: Professor Steven Bauer

Text: Google has the answers to most all of your questions, after exploring Google if you still have thoughts or questions my Email is open 24/7.

Each week you will receive your Course Materials. There will be two kinds of highlights: a) Prof's Guidance, and b) Italic within the text material. You should consider printing the Course Materials and making notes of those areas of questions and perhaps the highlights and go to Google to see what is available to supplement those highlights. I'm here to help.

Freshman Year

Course 101 - Stock Versus Other Investments
Course 102 - The Magic of Compounding
Course 103 - Investing for the Long Run
Course 104 - What Matters & What Doesn't
Course 105 - The Purpose of a Company
Course 106 - Gathering Information
Course 107 - Introduction to Financial Statements
Course 108 - Learn the Lingo & Some Basic Ratios

Sophomore Year

Course 201 - Stocks & Taxes
Course 202 - Using Financial Services Wisely
Course 203 - Understanding the News xxx
Course 204 - Start Thinking Like an Analyst
Course 205 - Economic Moats
Course 206 - More on Competitive Positioning
Course 207 - Weighting Management Quality

Junor Year

Course 301 - The Income Statement
Course 302 - The Balance Sheet
Course 303 - The Statement of Cash Flows
Course 304 - Interpreting the Numbers
Course 305 - Quantifying Competitive Advantages

Senor Year

Course 401 - Understanding Value
Course 402 - Using Ratios and Multiples
Course 403 - Introduction to Discounted Cash Flow
Course 404 - Putting OCF into Action
Course 405 - The Fat-Pitch Strategy
Course 406 - Using Morningstar as a Reference
Course 407 - Psychology and Investing
Course 408 - The Case for Dividends
Course 409 - The Dividend Drill

Graduate School

Course 501 - Constructing a Portfolio
Course 502 - Introduction to Options
Course 503 - Unconventional Equities
Course 504 - Wise Analysts: Benjamin Graham
Course 505 - Wise Analysts: Philip Fisher
Course 506 - Wise Analysts: Warren Buffett
Course 507 - Wise Analysts: Peter Lynch
Course 508 - Wise Analysts: Others
Course 509 - 20 Stock & Investing Tips

This Completes the List of Courses.

Wishing you a wonderful learning experience and the continued desire to grow your knowledge. Education is an essential part of living wisely and the experiences of life, I hope you make it fun.

Learning how to consistently profit in the Stock Market, in good times and in not so good times requires time and unfortunately mistakes which are called losses. Why not be profitable while you are learning? Let me know if I can help.


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