2006-10-13 / Columnists

Focus On Financial Affairs

Long-Term Investing: The Tax Advantage
Commentary By Stephen J. Levine President, Harbor Financial, Inc.


Under current tax laws, if you hold an investment for less than a year and realize a gain when you sell, you will be taxed on the gain at your ordinary income tax rate. If you sell after 12 months, your long-term capital gains tax rate will be 15%.

If you are in a high tax bracket, the ability to reduce your long-term capital gains tax to 15% is a powerful argument for you to exert more control over whether your investment gains are taxed as ordinary income or at 15%. When you calculate the effect on return that the rate change makes possible, it is clear that every taxable dollar should be targeted for the 12-month long-term capital gains rate. No one can consistently predict what the return on an investment will be, but if you invest taxable dollars, and control that holding period, you can predict and control the percentage of your gain, if any, that you retain.

The Calculation

The reduction of the long-term capital gains tax rate to 15% on a 12-month holding gives high tax-bracket investors the opportunity to significantly reduce their tax penalty. If you're in the 35% tax bracket, and your $100,000 investment of taxable dollars returns 10%, producing a $10,000 gain, your tax liability could be taxed as ordinary income at 35%, $3,500 in taxes,or taxed at 15% capital gains tax rate, $1,500 in taxes.

For investors who hold investments for 12 months or longer, the 15% capital gains tax rate can reduce the amount of gain lost to federal taxes by 20% versus the highest ordinary tax rate. This differential is based solely on taking full advantage of the lower capital gains rate. It's an opportunity for savings that not enough investors consider.

It's an opportunity that, I believe, indicates the need for a careful review of the investments you use for your taxable dollars. For the past decade or so, enormous amounts of capital have flowed into mutual funds. These investment vehicles may now be less attractive for some taxable investors, because they may not enable you to manage your investments as well in terms of minimizing taxes.

Many mutual fund managers employ active, short-term trading in pursuit of total return. This approach will often deny tax-affected investors the benefit of the lower capital gains tax rate, and could expose some of their return to federal income tax rates up to nearly 35%.

The Alternative

In this environment, individually managed accounts should be considered for investing taxable assets. Although this investment alternative, like most others, carries a degree of risk that may vary from portfolio to portfolio, it enables you to retain the benefits of professional management. This type of investment also offers a degree of control over the timing of buy/sell decisions that can help you keep more of any gains you realize. The fees associated with individually managed accounts can be highly competitive with the costs of mutual fund investing.

For your taxable assets, the individually managed account combines tax-sensitivity, professional management and customization, an attractive combination.

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