Foolish Workshop
By
Tax Perspectives
DES PLAINES, IL (Oct. 21, 1999) -- If you've been using the Workshop strategies as part of your portfolio, you're probably very pleased with the results. You might also be wondering what those gains will do to your tax bill. Or perhaps you're thinking of trying a Workshop screen and are wondering what your real-life, after-tax returns might be.
Moe Chernick is already covering this in a series on costs, with an emphasis on spreads and commissions costs. Here, we'll try and explain some tax basics and show you how to come up with a number that can be plugged into Moe's after-cost return formula.
While it is only prudent to study tax issues and adjust your investing strategies accordingly, don't let the tax "tail" wag your investment "dog." Your main concern should be with selecting screens that are appropriate for your situation and risk tolerance. Earning 15% after taxes is always better than earning 10% tax-free. If you are investing to make money, it's more important to maximize your net return than to minimize your taxes.
Before going any farther, I will make a DISCLAIMER: The following is a general summary of some tax rules, and should not be construed as professional advice. Please consult an appropriate tax advisor for a comprehensive analysis of your specific situation. Actual mileage may vary.
Now that that's out of the way, what should you be aware of? First, if your investments are in an IRA, congratulations! There are no tax consequences until you take a distribution (and not even then, if it's a Roth IRA). Just sit back and let your investments grow. If you are about to take a withdrawal for retirement or some other reason, go to the All About IRAs or Tax Strategies areas for more information. As a general rule, you should let your money sit in a tax-advantaged plan for as long as possible.
But what if you're investing outside of an IRA or 401(k)? As you know, you will have to pay taxes on any gains. Federal tax rates on ordinary income range from 0% to 39.6%. There are also state taxes to consider, which usually are at much lower rates (Illinois has a flat 3% rate), but can sometimes be substantial (California's top rate is 9.3%). If you itemize deductions on your federal tax return, you can deduct any state taxes you have paid, reducing your effective state tax rate. Every little bit helps. First, we'll focus on federal taxes.
Returns from screens come in two flavors: dividends and capital gains. Dividends are taxed as ordinary income, the same as your regular wages (at about 28% for most of us).
Capital gains (or losses) are the amounts recognized on the sale of securities, and are (generally) the difference between the purchase price and the sale price including commissions. If you bought XYZ Co. for $8,000 and sold it for $13,000, you would have a $5,000 capital gain. If a security is held one year or less, then the gains are short-term, and are taxed at the same rate as dividends, i.e., your ordinary tax rate.
If the security is held for over a year, then the gains are long-term, and are taxed at a maximum rate of only 20% (if you're in the 15% bracket, then the rate is only 10% for long-term gains). This is why annual stock strategies recommend holding for "a year and a day."
All gains and losses are netted against each other. Capital losses offset capital gains first, but if you have losses left over, up to $3,000 in losses can be applied against your ordinary income. Losses over $3,000 can be carried forward to subsequent years.
With this information, it's easy to estimate after-tax returns. We'll use two examples.
A) The Foolish Four has shown a long-term average return for January portfolios of about 20% per year, with about 4% from dividends and the remaining 16% from long-term capital gains (Foolish Four stocks are held for a year and a day). Assuming you're in the 28% bracket, your approximate tax burden would be:
For dividends: 0.04 * 0.28 = 0.0112
For LTCG: 0.16 * 0.20 = 0.032
0.0112 + 0.032 = 0.0432
So, you would lose about 4.32% to taxes, leaving an after-tax return of about 15.86%.
If you are using Moe's formula, you would do it a bit differently. Since two tax rates apply, you need to "weight" the two rates. Eighty percent of the returns are being taxed at 20%, and the remaining 20% is being taxed at 28%, so the tax rate is 21.6% (0.8 * 0.20 + 0.2 * 0.28 = 0.216).
B) PEG4-Semi-annual (six-month hold) has backtested returns of about 40%, all of which is from either dividends or short-term capital gains. Assuming a 28% tax rate, your tax burden would be:
0.40 * 0.28 = 0.112, or 11.2%
Your after-tax return would be 40% - 11.2%, or about 28.8%.
If you are in a higher or lower tax bracket, adjust your calculations accordingly. Also note that state taxes are not factored in, yet. Since state taxes are deductible for federal purposes, the extra burden will be pretty small in most states. Applying your state rate to what you get to keep after taxes (72% if you are in the 28% bracket) gives you your "effective" state tax rate if you itemize deductions.
For example, let's use Illinois' state tax rate of 3%.
Effective tax rate for persons in the 28% tax bracket who itemize deductions:
0.03 * 0.72 = 0.0216, or 2.16%
Add that to the 28% you pay on dividends and short-term gains (0.28 + 0.0216 = 0.3016) gives you a combined federal and state tax rate of 30.16%. The PEG's combined state and federal tax burden is (0.40 * 0.3016 = 0.12064) for an after-tax average annual gain of 27.9%.
The tax rate to use with Moe's formula is the combination of the federal rate and the effective state rate: 0.3016.
Note that screens with holding periods of less than a year suffer the double-whammy of higher taxes and (as Moe has explained) higher trading costs. If at all possible, you should use these screens in an IRA, assuming the amount you can invest is large enough to handle the commissions and spread.
Tune in next week when we'll talk about estimated taxes and tell you why an IRS penalty is not necessarily a reason to panic. (I'm not kidding!) Feel free to stop by the Workshop message board with questions and comments.
Until next week, Fool on!