How to Shrink Taxes on Investments

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Stocks did well in 2006, but if you don't plan ahead, you'll forfeit a lot of the gains to Uncle Sam.

 

Investors have good reason to be pleased. During the first 10 months of 2006, the Standard & Poor's 500-stock index returned 12.1%. But along with those gains comes an inevitable cloud: taxes. Any time you sell a winner, you must pay capital gains taxes at rates of up to 15% on long-term positions.

 

For mutual funds, the problem is particularly severe. Fund portfolio managers often make short-term trades, and shareholders can be taxed at rates of up to 35% on the profits. All in all, the IRS should do well this year, collecting more than $20 billion in taxes from mutual fund investors alone. That's up from $15 billion last year and a measly $1 billion in 2003.

 

But not all investors need pay steep bills. By adopting easy strategies, you can dodge the taxman. For example, if you buy individual stocks, don't sell them. That way you never owe any capital gains taxes.   

 

Another tactic is to buy a tax-managed fund. These rarely sell stocks in their portfolios and try to offset any gains with capital losses. Top choices include Fidelity Tax-Managed Stock and Vanguard Tax-Managed Growth. The latter has returned 11.4% annually for the past three years, out-doing two thirds of its large-blend competitors. The fund has $3 billion in assets.

 

Another smart move is to shelter investments in retirement funds. For high-income investors, the already formidable advantages of retirement accounts were improved last year when Congress passed the Tax Increase Prevention and Reconciliation Act. Consider Roth accounts. In the past, you could put assets in a Roth, and never pay any taxes on them—even when you made withdrawals. There was a catch: taxpayers with adjusted gross incomes of more than $160,000 were not eligible for Roth IRAs and 401(k)s.

 

Under the new legislation, anyone—regardless of income—can use Roth 401(k)s. With a Roth 401(k) you can put up to $20,000 a year into a tax shelter, and you need never make any withdrawals. If your heirs withdraw the money, they will owe no taxes. “Congress has presented a huge opportunity for investors,” says James Lange, a Pittsburgh CPA. “By taking advantage of the new legislation, wealthy families can save tens of thousands of dollars in taxes.”

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