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MONTHLY TAX NEWSLETTER - MAY 2000

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Two Common Mistakes Made by Investors

These days, more and more people are investing in the stock market. With the bull market lasting most of the nineties, and on-line investing making it easier for the small investor to purchase individual securities, there's no wondering why.

The goal for people who invest in individual securities should be to maximize their after-tax return on their investments. A few of the basic tax rules that all investors should be aware of are as follows:

  • Investments held for more than one year before being sold are generally taxed at a maximum tax rate of 20% (except for people in the 15% tax bracket whose capital gains will be taxed at 10%). Investments held for less than one year are taxed at the investor's marginal tax rate of either 15%, 28%, 31%, 36% or 39.6%.

  • Investments held in retirement accounts are not taxed until such time that distributions are made from those accounts. For that reason, any trading activity done within retirement accounts is tax-deferred. Once distributions are taken from your retirement accounts, they are taxed as ordinary income at your marginal tax rate. No portion of the distribution from a retirement account will generally qualify for the lower capital gains treatment, even if the individual investments in the retirement account have been held for more than one year.

  • If you lose money on the sale of one of your investments, the losses realized during the year (plus losses carried forward from previous years) can be used to offset other capital gains realized during the year. If your capital losses exceed your capital gains, up to $3,000 of the excess losses can be used to offset your wages and other income. Any excess losses will be carried forward indefinitely, and will be grouped together with other losses realized in that year.

Mistake #1: Having your capital losses disallowed due to the WASH SALE rules

Generally, if you lose money on the sale of one of your investments, you can use those losses to offset other capital gains realized during the year. If your losses exceed your gains, you are allowed to use up to $3,000 of the excess losses to offset any other type of income earned during the year.

There is one exception to this rule. If you sell a stock for a loss, and buy back the stock during the period beginning 30 days before the date of sale and ending 30 days following the date of sale, the loss will be DISALLOWED AS A WASH SALE. Essentially, the government feels that the sole motivation of your selling the stock was to save taxes, and they frown upon transactions that have no other basis except to cut your tax bill.

An example of a wash sale is as follows. Say you purchased 100 shares of e-garbage.com the day after it went public at $100 per share. When the market tanked last month, your $10,000 investment was only worth $500. You decide to sell the stock on 5/1/00 for $500, thus realizing a loss of $9,500. Two days later, you read a positive story in the paper about e-garbage.com, and decide to buy another 100 shares. Since you bought at least as many shares as you sold during the 61 day period beginning 4/1/00 and ending 5/31/00, the $9,500 capital loss will be disallowed as a wash sale. The only person who benefited from the sale of stock on 5/1 and the re-purchase on 5/3, therefore, was your brokerage firm.

This winter, we encountered quite a few taxpayers who had losses disallowed as a result of the wash sale rules. If you sell a stock at a loss, you need to keep the wash sale rules in the back of your mind.

Like most IRS rules, there are a few ways to get around the wash sales rules.

  • After selling the stock in your taxable account, you can purchase the same stock in one of your retirement accounts. In the example above, you could have bought 100 shares of e-garbage.com in your IRA account the same day that you sold the shares in your non-retirement accounts, and could have still used the $9,500 loss to offset other capital gains realized during the year.

  • You could keep your fingers crossed and wait 31 days before purchasing additional shares of e-garbage.com. Remember, once 31 days pass from the date your sold the stock, the wash sale rules no longer apply.

  • You could purchase stock in a similar company. After selling e-garbage.com, you could have purchased an equivalent amount of e-trash.com and still claim the $9,500 loss you realized.

Mistake #2: Keeping your tax money invested right up until the 4/15/00 deadline

During the past four or five years, people have forgotten that investing in the stock market can be risky and that you can actually lose money if the stocks your invest in go down in value.

Take a look at the following true story. We had a client who had a great year investing in various stocks during 1999. This client started the year with a stock portfolio worth $20,000 and ended the year with a portfolio worth $100,000. This client was a short-term investor, never holding onto a stock for more than a month. Additionally, this client had no additional non-retirement account money except for this stock portfolio.

Since this client held none of his investments for more than a year, his combined federal and state tax liability on the $80,000 of short-term capital gains was $28,000, which he needed to pay on 4/15/00.

Now for the problem. On January 1, 2000, this client did not set aside $28,000 from his investment portfolio to pay his taxes. Instead, he kept the $100,000 fully invested. Well, if your remember correctly, the stock market (especially NASDAQ) took it on the chin during the first few weeks of April, and on April 15th, our client's stock portfolio was only worth $45,000. He had to liquidate more than half of his portfolio to pay his taxes. On April 16, 2000, his portfolio, which was worth $20,000 on January 1, 1999, was only worth $17,000, which represents a decrease of 15%.

If the client had set aside $28,000 for taxes, and only kept $72,000 invested, his portfolio would have still been worth $32,400 after paying his 1999 tax liability, which represents an after-tax return of more than 60% on the original investment of $20,000.

The Moral......If you have net gains from selling stocks during the year, on December 31st of that year, set aside enough money in either a bank account or a money market account to cover the taxes on those gains. You are not in any position to take even the smallest amount of risk with your the money needed to pay the taxes owed on your realized capital gains.


TO DO LIST FOR MAY, 2000

Month

Income Taxes

Saving and Investing

May

  • Spring Cleaning!! Good time to make semi-annual donation of clothing and household items to charitable organizations


1999 & 2000 TAX FACTS

  • For 1999, the standard deduction for a single individual is $4,300 and for a married couple is $7,200. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes, real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses. For 2000, the standard deduction for a single person will be $4,400 and for a married couple will be $7,350.

  • For 1999, the personal exemption is $2,750. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. For 2000, the personal exemption has been increased to $2,800.
  • The maximum earnings subject to social security taxes has been increased to $76,200 in 2000 from $72,600 in 1999.
  • The standard mileage rate has been increased back to $.325 per mile as of January 1, 2000 from a rate of $.31 per mile as of April 1, 1999.
  • The maximum annual contribution to a 401(k) plan or a 403(b) plan has been increased to $10,500 in 2000 from $10,000 for 1999.


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