<THE FOOLISH FOUR>

Taxes: Pay now
by Ann Coleman
(TMF AnnC)

Reston, VA (September 30, 1998) -- If you can't avoid paying taxes on your retirement accounts entirely, at least pay them later. This is one case where putting off until tomorrow is a great idea. Not as good as the Roth IRA we discussed Monday, but the next best thing if you want to invest more than the IRA limits allow. (Good idea!)

There are two quite legal ways of paying taxes later. First, in a traditional IRA, your money grows tax-free. There are no capital gains taxes to pay when you sell a stock. You can buy and sell all day long (but don't) with no tax consequences. That is a tremendous advantage.

The other way is to just not sell your stocks. That's right. As long as you don't sell, no taxes are due. This applies to non-IRA accounts, as well.

In other parts of this forum, we often talk about the advantages of a buy and hold approach. One advantage is that you won't be sitting around the bridge table at the Seniors Center telling the Old Investor equivalent of "The One That Got Away" stories: I sold IBM in '93 after it dropped to $25. (Everyone clucks sympathetically, but they're all thinking: What a schmuck!) Another major advantage is that your investment can grow tax-free (well, tax-deferred) for years and years and years and years.

Every year, the money that you don't pull out for the tax man stays in the account. You get to keep 80% of the money that this money makes, and 80% of the money that that money makes. This is the miracle of compounding at its best. In this respect, a good buy and hold strategy, like we focus on in the Cash-King Portfolio, functions like a traditional IRA -- but with lower taxes! Yes, it's true.

A Dow Dividend approach will not always beat out a Buy and Hold approach when taxes are taken into consideration. (Of course, you have to pick good stocks to buy and hold.) But let's just consider the mechanics of relatively high turnover strategies like the High Yield 10 or the Foolish Four vs a traditional IRA and a Buy and Hold approach. What happens to those great returns when you have to pay capital gains taxes every time you sell stock at a profit?

With a traditional IRA you pay no taxes on your earnings, but when you start making withdrawals from that account, you pay income tax at regular earned income rates. When you buy and hold a stock for many years, the stock's price appreciates tax-deferred, and when you eventually sell the stock to finance that lovely retirement condo on the beach, you don't pay at regular income tax rates, you pay at the lower, long-term capital gains rate.

Here's how it works. The table below assumes the same rate of return (16%) in each account (getting the same return is the trick � we'll talk more about that later). It compares a High Yield 10 strategy in a regular brokerage account with a High Yield 10 strategy in an IRA and a Buy and Hold strategy in a brokerage account. In the first account, taxes are paid yearly. In the other two the money compounds unrestrained by taxes. For simplicity we are assuming that each account is cashed out at the end of 20 years at which time any taxes due are paid. The high turnover account pays 20% of each year's capital gains at the beginning of the following year. At the end of 20 years, the IRA account pays taxes at the marginal rate of 28% on its gains, and the Buy and Hold account pays 20% on its capital gains. (Got all that? Whew!)

 
               HY10 Brok.   HY10 IRA   Buy&Hold 
 Starting Value  $10,000     $10,000    $10,000 
 End of Year 1   $11,600    $11,600    $11,600 
 Year 2          $13,085     $13,456    $13,456 
 Year 5          $19,033     $21,003    $21,003 
 Year 10        $35,504     $44,114    $44,114 
 Year 15        $66,230     $92,655    $92,655 
 Year 20       $123,544    $194,608   $194,608 
 Year 25        $230,458    $408,742   $408,742 
  
 Total yearly 
  taxes paid     $44,092          $0         $0 
 Taxes paid 
  at withdrawal   $5,403    $111,648    $79,748 
 Account Value 
  after taxes   $225,054    $297,095   $328,994 
 

So, how does this relate to the Foolish Four? Well, that's where the question of what kind of return you can get with a buy and hold strategy comes in. In our first example, I chose a reasonable return for a High-Yield 10 strategy and used that same return for the Buy and Hold strategy. If we run those same numbers, but assume a more typical return for the Foolish Four, say the 20% (a bit less than it has returned over the past 25 years), the difference is quite astounding. The Foolish Four, although growing far less briskly than it would in a tax-deferred account, still blew away the Buy and Hold strategy at 16%. In fact it grew to over $450,000.

The Cash-King Portfolio, of course, shoots for more than a measly 16% a year. In fact the managers are aiming to do better than the Foolish Four and the Fool Portfolio. Dream on! But for those of you who are curious, I ran the numbers again with higher returns for the Buy and Hold account. The break-even point was around 90%. In other words, in the 25 year scenario I ran, when the return of the Buy and Hold strategy was better than 89% of the return for the Foolish Four, the final dollar values were very close.

Of course, we don't know what kind of returns each strategy will generate over the next 25 years. Welcome to the real world. This is where the rubber hits the road. You, and you alone, have to decide how to deploy your assets. If you think you can pick stocks that are strong enough to come close to the Foolish Four's returns, you might do better with a Buy and Hold strategy, especially when taxes are factored in.

Fool on and prosper!

Current Dow Order | 1998 Dow Returns

What Happened to Robert Sheard?

09/30/98 Close

Stock Change Last -------------------- UK + 1/4 43.13 IP -2 3/8 46.63 MO - 3/16 46.06 EK - 5/8 77.31

Day Month Year FOOL-4 -1.41% 9.41% 10.84% DJIA -2.94% 4.03% -0.83% S&P 500 -3.05% 6.21% 4.80% NASDAQ -2.32% 12.98% 7.86% Rec'd # Security In At Now Change 12/31/97 206 Eastman Ko 60.56 77.31 27.66% 12/31/97 289 Int'l Pape 43.13 46.63 8.12% 12/31/97 276 Philip Mor 45.25 46.06 1.80% 12/31/97 291 Union Carb 42.94 43.13 0.44% Rec'd # Security In At Value Change 12/31/97 206 Eastman Ko 12475.88 15926.38 $3450.50 12/31/97 289 Int'l Pape 12463.13 13474.63 $1011.50 12/31/97 276 Philip Mor 12489.00 12713.25 $224.25 12/31/97 291 Union Carb 12494.81 12549.38 $54.56 CASH $754.73 TOTAL $55418.36