Saturday, June 30, 2007

Investing with Your Eye on Taxes

Unfortunately with investing, as with just about any other
activity that generates income, gains are taxable. That
downside doesn’t mean that you shouldn’t try to invest successfully.
But you should realize that you do pay taxes on
investment gains. Consider the following:

Savings accounts

The gains on simple savings accounts, CDs, and money market
accounts are taxed as income at the local, state, and
federal level. Banks and financial institutions report these
gains to the IRS and state tax offices, just as all investment
gains are reported.

Mutual funds

With mutual funds, unfortunately, you have to pay tax each
year on the capital gains and dividends that the fund distributes
to each of its shareholders. You also have to pay taxes
on your own gains when you sell shares — another reason
for a long-term buy-and-hold strategy. The exceptions are
funds that invest in U.S. securities. You still have to pay federal
income tax on any gains, but you’re free of state and local
tax in most situations.

Although some people believe that municipal bond funds are
free of federal income tax, that’s only true of municipal bond
investments themselves. You pay taxes on capital gains on any
profits that a municipal fund makes from selling bonds.


With stocks, you don’t pay taxes on your gains until you sell
your shares — a
feature which fans of stock investing say is
a clear advantage in the long run. The downside, however, is
that when you do cash in shares down the road, your tax
bracket or the tax rate may have increased.
If you do have a
stock loss (
which means a stock is worth less
than what you bought it for), but the stock is one you want
to own, consider selling the stock and rebuying shares at a
lower price. The IRS allows you to consider this a wash sale,
so you won’t have to pay capital gains tax. Note that you must
wait 31 or more days before you can buy back the stock or
else the IRS doesn’t allow the deduction.


Price appreciation (if any) on a bond — whether it is a corporate,
government, or municipal bond — is taxable when
the bond matures. Interest on municipal bonds is exempt
from federal tax, but may be subject to state and local tax
(depending on if you live in the state or locality doing the
issuing). Interest on U.S. government bonds is exempt from
tax at the state level, but taxable at the federal level.

If you buy a
bond from Fannie Mae or Ginnie Mae (
quasi-government agencies that guarantee mortgages), then
gains are taxable at the local, state, and federal level.
Tax-deferred investing
Don’t forget to take advantage of any form of tax-deferred
investing available to you. Max out on the retirement plans
offered to you at work (such as your 401(k) plan). Investing
in this way really does boil down to a choice of paying yourself
or paying the IRS.

With retirement plans such as a 401(k), you enjoy the added
bonus of being able to deduct your contributions, up to a
maximum of 15% of what you earn, from your income each
year for tax purposes. Now that’s hard to beat. The maximum
amount that you can deduct depends on the plan. Some
plans allow 8%, some 10%. But no plan is allowed, by law,
more than 15%.

Contributions made to a 401(k) plan are deductible from
gross income for income tax purposes. If you do your taxes
yourself, you deduct your overall annual contribution from
your gross income. If an accountant or attorney does your
taxes, she or he does the deduction for you.

Just as hard to beat is the Roth IRA. If you have adjusted
gross income under $95,000 as an individual, you can tuck
away $2,000 in a Roth IRA each year and begin to take distributions
tax-free when you hit the age of 591⁄2. If you’re married
and you and your spouse have a combined adjusted gross
income of $150,000 or less, you can tuck away $4,000 a year.
Unlike regular IRAs, Roth IRAs allow investments even if
you’re enrolled in an employer-sponsored retirement plan.
The same goes for self-employed folks. With the Roth, you
get tax-free capital gains every year, and you get to take withdrawals
tax-free when you hit retirement age at 591⁄2, provided
you’ve had the account for at least five years.

Developing a Dollar Cost Averaging Plan

No one can afford to have his or her investing plan be forgotten
or relegated to the back burner. You need to set up a
plan for making set, regular investments. This way, you can
ensure that your money is working for you even if your best
intentions are diverted.

Dollar cost averaging is a way to ensure that you make fixed
investments every month or quarter, regardless of other distractions
in your life. Dollar-cost averaging is a simple concept:
You invest a specified dollar amount each month
without concern about the price per share or cost of the
bond. The market is fluid — the price of your investment
moves up and down — so you end up buying shares when
they’re inexpensive, some when they’re expensive, and some
when they’re somewhere in between. Because of the commission
cost to buy small amounts of stocks or bonds, dollar
cost averaging is better suited for buying mutual funds.
If you have a

401(k) plan at work, you already have experience
with dollar cost averaging. You fill out the forms for the
plan and direct your payroll department to take a certain dollar
amount or percentage of your pay every payday and use
it to buy the mutual funds, stocks, bonds, and/or money
market account you’ve selected. Investing this way is important
for your retirement accounts and your financial plans:
It’s the only way most of us can grow our money in a consistent

In addition to helping you overcome procrastination about
saving for investments, dollar cost averaging can help you
sidestep some of the anxiety many first-time investors feel
about starting to invest in a market that can seem too overheated
or risky. With set purchases each month or quarter,
you buy shares of your chosen investments regardless of how
the market is doing.

Dollar-cost averaging isn’t statistically the most lucrative way
to invest. Because markets rise more often than they decline,
you’re better off saving up your money and buying stocks,
bonds, or mutual funds when they hit rock bottom. But dollar
cost averaging is the most disciplined and reliable way to
invest. Consider this: If you set up a dollar-cost averaging
plan now, then in 10, 20, or 30 years, you’ll have invested
every month in between and accumulated a pretty penny in
the interim.

Most mutual funds let you start out on a dollar cost averaging
plan (or automatic investing plan, as they’re also called)
for as little as $50 or $100 a month. The only catch is that
you have to sign up to allow the fund to take the money from
your checking account each month. To find out if the funds
you’re interested in offer the service, look for the information
in their prospectuses or call their toll-free shareholder services
phone number.

Knowing When to Sell

Of course, maybe one or more of your investments isn’t performing
up to your standards. This kind of letdown happens
to the best of us, and you can count on a disappointment
once or twice in your investment life. When underperformance
hits home with one of your investments, take a deep
breath and try to figure out what’s happening.

Figuring out how long to hold on to an investment that isn’t
producing any growth is a challenge. You have to first determine
what is keeping the investment on the rocks. The following
sections offer a look at why an investment may be

When you sell a stock, bond, or mutual fund, make sure that
you find a
suitable replacement and don’t leave the cash lying
in your checking account, where it may be pilfered away by
life’s daily expenses.

Is the economy the reason for your
investment’s slump?

Is the entire market taking its lumps? If so, your then investment
isn’t immune. If one or more sectors of the stock market
are taking a licking, consider the impact to your stock,
bond, or mutual fund. A sluggish economy, or one that is in
retreat, can play havoc with investments. Investments are
long-term endeavors. Don’t sell just because of an economic
downturn. You’ll take a loss.

An economic downturn can create a buying opportunity if
it sends the price of stocks spiraling downward.

Is your stock falling behind?
If a stock is struggling, look at the company. Forget about
what’s happened to date for a moment. If you discovered the
company again today, would you buy it? Do some future
analysis on the company’s prospects. Don’t let your answer
be clouded by negative feelings about the past few months
or years. If you bought the stock because you believed that
the company was well-positioned for a turnaround due to
new and competitive products or services, sales, profits, or
other facets of its financial position, hang on a bit more. The
last thing you want to do is take a loss on a stock that may
turn around a few days or months after you give it the boot.

At the same time, if you decide you wouldn’t buy the stock
again today, or some of the economic reasons that attracted
you to the stock in the first place haven’t panned out, selling
is okay.

Is your bond slipping behind?
If a bond is doing poorly, maybe because the stock market is
booming (typically, when the stock market is doing well,
bonds are lagging, and vice versa), ask yourself what cost you
can expect from hanging on to the bond until maturity.
Compare that expense with what it will cost you to sell the
bond. If interest rates rise substantially, say to 15%, and
you’re hanging on to a
bond paying 4%, you might well be
better off selling the older issue and buying a new bond.

Is your mutual fund fumbling?

If your mutual fund isn’t performing up to snuff, then look
at the fund manager’s style. If the stock market is growth-oriented
and your manager is a value manager who looks for
bargains, you may be wise to hang on. Value-style investing
comes in and out of favor, and you wouldn’t want to miss the
upside. Of course, if an inept mutual fund manager is the
only reason you can find for the lagging performance, you
can sell. Just try to wait until a fund’s performance has been
impaired for at least two years in order to avoid unnecessary

More Investment Index

The Wilshire 5000

Want a good look at how the overall U.S. stock market is
doing? The Wilshire 5000 tracks a huge universe of stocks
— in fact, it lists almost every publicly listed stock, including
those listed on the New York Stock Exchange, the
American Stock Exchange, and the Nasdaq Composite.
That’s a pretty definitive look at the large-, medium-, and
small-company stock markets.

This is not a must-read index, especially on a daily basis, but
it is an index investors want to at least know about and have
the option of viewing once in a while. It’s the largest index
going. It gives an investor a broad sense of how the U.S. stock
market overall is faring and in which direction stocks are
headed. More mutual funds have also started investing in
stocks listed in the Wilshire 5000, which gives investors total
U.S. stock exposure.

S&P Mid Cap 400

The S&P Mid Cap 400 index measures the performance of
400 medium-sized companies. If you’re interested in investing
in mid-size companies, or mutual funds that do — and
there are a number of success stories in the mid-sized
range — this is a good benchmark to use to gauge your own

The Russell 2000

The Russell 2000 is the most widely used benchmark for the
smaller company market. (Other small company performance
indexes include the S&P Small Cap 600, the Wilshire
Small Company Growth Index, and the Wilshire Small Company
Value Index.)

The Morgan Stanley Capital International

Emerging Markets Index

The Morgan Stanley Capital International Emerging Markets
Index looks at smaller companies that are operating in
up-and-coming and also sometimes highly volatile developing
markets around the world.

The Morgan Stanley Capital International

Europe, Australia, Asia, and Far East
(EAFE) Index

The Morgan Stanley Capital International Europe, Australia,
Asia, and Far East (EAFE) Index, considered one of the more
prominent, tracks more than 1,000 foreign stocks in 20
countries. This is the big daddy for international investors
and money managers. It tells you how the international stock
market is faring, and if you own stock or a mutual fund that
invests globally, how you’re doing in comparison.
Lehman Brothers Aggregate Bond Index
As the name suggests, the Lehman Brothers Aggregate Bond
Index represents an aggregate of the performance of a
of bonds, including U.S. Treasury bonds and corporate
bonds. For investors in U.S. bonds or bond funds, this is the
benchmark for relative performance and the direction of the

Lehman Brothers Long-Term High-Quality

Government/Corporate Bond Index

As its name suggests, the Lehman Brothers Long-Term High-
Quality Government/Corporate Bond Index looks at the universe
of higher-rated government and corporate bonds. To
make it onto the index, a bond must have a maturity or duration
of 15 years or more and a rating of A or better from

If you’re interested in making long-term investments in highquality
bonds, this benchmark gives you an idea of the type
of performance you can expect and the way the market is faring
right now.

The Nasdaq Composite Index

In some senses, the Nasdaq Composite Index is sometimes
seen as a competitor to the S&P, but the Nasdaq Composite
is actually very different. For starters, Nasdaq measures the
stock performance of 5,500 companies, nearly half of them
in the telecommunications and high-tech arena, and all of
them found in the Nasdaq market.

The index includes companies
such as Apple, Intel, MCI Communications, Cisco,
Oracle, Sun Microsystems, and Netscape.

As a result, the Nasdaq index is a good deal more volatile
than, for example, the Dow Jones Industrial Average and,
perhaps, the stock market at large. It’s also home to some of
the bigger success stories of the 1990s — many of which are
technology firms. The higher the potential for return an
investment has, the more the risk it carries.

Just like the Dow Industrial Average and the S&P
500, the
Nasdaq Composite gives the average performance of the
stocks in the index both as numbers and percentages. If Nasdaq
goes up, your newspaper might report that “Nasdaq was
up 1 point or 3% today.”

Although it will be increasingly important for investors to
watch the Nasdaq Composite in the days ahead and the performance
of some of its key stocks, it’s equally important to
look at Nasdaq in relation to the S&P 500 — and even the
Dow — to get an overall sense of how the stock market is
doing. For example, if you are a short-term trader (day trader)
then the Nasdaq is where you want to be. The Nasdaq stocks
can offer great potential for profit and, unfortunately, for loss,
as well.

The Standard & Poors 500

Also called the S&P 500, the Standard & Poors index, which
most professional money managers say that they use as the
benchmark against which they measure their own investing
prowess, is the one that has become the dominant benchmark
in U.S. investing in recent years.

Although the S&P is not really the appropriate measure of
performance for bonds or the stocks of small-sized companies,
nor the apt standard against which to judge international
investments, the index is still used to gauge these
investments’ performances anyway.
1 2 3 4 5
Line = index
Bars = specific mutual fund

The S&P 500 tracks the performance of 500 stocks, comprised
of 400 industrial companies, 40 utilities, 20 transportation
companies, and 40 financial firms. A committee at
S&P reviews the companies periodically and may replace up
to 30 for reasons that include, for example, bankruptcy.
The performance of the 500 stocks is run through a computer
software program that calculates a daily measure of the
market’s rise or fall as well as an overall performance figure.
These are the numbers you hear reported on the nightly
news, see in the newspapers, and can view on your computer
screen if you log on to a personal finance Web site.

The S&P tells you the average performance of the stocks in
the index. This performance is reported as both numbers and
percentages. If the S&P goes up, your newspaper might
report that “
the S&P
went up 2
points or 6% today.” When
the stock market is doing well the numbers and percentages
go up. When it’s doing poorly, they go down.

The S&P 500 is home to some of the hottest stocks of the
late 1990s, including AOL and Dell, the latter of which gave
investors an unrivaled 79.7% average annual return, not for
a day, not for a month, but for 10 years. With so much fanfare,
the S&P has become the index to beat for mutual fund
managers. Outperforming it is cause for celebration — only
1 out of 10 mutual fund managers do so in any five-year

Purchasing Mutual Funds

When you are ready to invest in a mutual fund, you can
either work through a broker or, in many cases, you can buy
directly from the mutual fund company. Many funds offer a
toll-free number for placing orders, and you can buy shares
of their funds.

Unlike stocks, you don’t have to specify the number of shares
you want to buy. You tell the fund company or broker that
you want to invest a
stated amount, and the fund or broker
tells you how many shares you will get.

Unlike stocks, mutual
funds sell partial or fractional shares.
A mutual fund company can’t sell you shares of a fund unless
you have first received the prospectus for that fund. Whether
you call or request the prospectus on the Web, you have to
give your name and address. Fund managers need this data
to prove that they have fulfilled their obligation to supply
you with a

When you begin to look into mutual funds, pay close attention
to those that come in families — preferably big families.
The term family refers to companies that offer several
different kinds of funds. How big is big? Think in terms of
ten or more funds. You can spot these families easily by looking
at the mutual fund reports in the business section of your
daily paper.

You typically see some kind of headline in the
columns followed by a list of funds offered by a particular
firm. It’s easy to spot the big families at a glance; these include
Fidelity, Oppenheimer, T. Rowe Price, and Vanguard.
Families of funds that charge commissions (also called loads
or load charges) provide the opportunity to switch among
their funds without paying additional commissions. You can
save considerable money with this option over the long term.
Make sure to check out this possibility.

A mutual fund has professional management, which comes
at a price. You, the investor, pay for this management, either
through commissions you pay when you buy or when you
sell and other fees that you are billed for periodically. These
fees reduce your return on investment and can run as high
as 7 to 8% a year, but 2% or lower is more common.
No-load funds don’t charge sales loads. No-load funds are
available in every major fund category.

Although not all mutual fund companies charge commission,
you need to know that the term “
load” is often used in two
ways. One is to specify commission charged when you buy
a fund (referred to as front-end load), and the other refers to
commission charged when you sell your shares in a fund
(known as back-end load).

Many investors wonder why they should pay a commission
to buy shares of a mutual fund when they can buy a similar
fund without a commission. The answer is that, in most
cases, there’s no good reason to buy a load fund rather than
a no-load fund. Several studies have indicated that the performance
of the two types of funds doesn’t differ. Unless you
come across that rare case in which the performance of a load
fund is so superior that it compensates for the load, save your
money and buy no-load funds.

Almost all mutual funds charge some kind of annual fee.
Analysts tally all these up into one measure called the expense
ratio, expressed as a
percentage of the invested funds. Expense
ratios range from about 0.75% to 2%, but a few charge as
much as 7%. The fund’s prospectus discloses the current
schedule of fees.

Beware of any load fund with a high expense ratio. Avoid
funds that charge a back-end load. These high fees and loads
are a large drain on an investment’s overall return; few funds
deliver performance consistently high enough to offset high