Taxes, Although Serious, Are Second

When it comes to free tax advice, income taxes are a rather complicated subject, and are discussed here only to suggest how they may affect your investing.

A major difficulty in writing about the income-tax aspect of investments is that people can own investments exactly alike, but the Federal income tax they pay can vary any­where from zero up, depending upon the owner's total tax­able income. Suppose each of two men has a $10,000 savings deposit in the same bank, each deposit paying $300 annual interest. One depositor's taxable income is zero, so that his net income from this investment is $300. The other man has such a big income that if his top-bracket tax rate of 91 per cent is applied to this $300 income, he has left after tax just $27. Conceivably one man can experience both of these ex­tremes, in different years of his life.

Only the income taxes assessed by the U. S. Government are considered here. A majority of the states, and some local governments, also have income taxes, and for some taxpayers those taxes can be larger than the Federal. The considerable differences among states and local governments in their rules and rates make it impractical to include them in this book. But when an investor figures taxes, he needs to remember to include both the Federal and whatever state and local taxes apply to him. And if he has investments in other countries, that brings him under still other rules not covered here.

In giving examples of the effect of Federal income taxes, it is customary to assume some tax rate such as 30 per cent. This is O.K., provided a reader understands that the example merely shows a method of figuring, and that the dollar results in the example probably are nowhere near to being correct for his own case.

In thinking about free tax advice, an investor runs the risk of paying too much attention to tax saving. A tax expert's job is to cut taxes for his clients; he is not concerned with the total effect of investing, and by following his advice too thorough­ly, a client can end up with poor investments.

A man desirous of holding his study of investments within the smallest practical tune limits probably had better spend that time in learning how to select investments, disregarding income taxes until it comes time to pay them. The extra results he can obtain by owning high-grade investments rather than mediocre ones are greater than any saving he can ac­complish by keeping one eye on taxes. This statement may be wrong for the rare man whose taxable income is large enough for income taxes to take half or more of his total income.

On the other hand, a man wanting to make a fairly thorough study of investing must make due allowance for income taxes, which is good free tax advice.

On a man's earned income, probably he cannot do any­thing about his taxes except pay them, and probably he loses nothing by delaying his figuring until shortly before payment is due. But in investing, he can have some leeway as to how much income tax he pays, and in what year. Before he buys an investment, an estimate of the tax on the income may affect his choice of which one to buy. And when he is thinking of selling an investment, a calculation of the tax ef­fect of the sale may change his mind as to the wisdom of selling. So on an investment, the time to figure income tax is before either buying or selling, not waiting until the tax is due.

Income taxes on investments can be avoided or reduced in numerous and varied ways. Although illegal, apparently by far the most common method is to "forget" some investments when making out the annual income-tax report. A man has a better chance of getting away with this when his total in­come is not much, if any, above average. The Internal Revenue Service seems to lack manpower enough to investi­gate more than a small percentage of all the tax reports by individuals, so naturally the larger a man's income, the more likely his report will be examined by the tax boys. When a man conceals from the government a substantial amount of income, he must be continually on the alert to avoid any action or record that might look inconsistent to some ob­server who might tattle, and the taxpayer's secrecy is likely to divert his attention from the selection of first-class in­vestments. Also, he may pay the penalty of being unable to sleep at night!

Investments with Lower Tax

A simple and perfectly legal way to avoid any Federal income tax on investments is to own nothing but bonds whose interest payment is exempt from that tax. The U.S. Government does not tax the interest paid on bonds issued by state governments or any of their subsidiaries. Super­ficially, the idea of owning tax-exempt bonds naturally sounds fine, and the higher a man's income-tax bracket, the more important it sounds. But unless a man has considerable capi­tal, the first snag in putting the idea into action is that none of these bonds is sold in a manner making it really practical to own them.

Some mutual-fund sponsors have been attempting to ob­tain tax exemption for an individual on dividends received from a mutual fund whose portfolio is invested entirely in tax-exempt bonds. If this plan becomes legal, a man can obtain a tax-exempt investment by merely buying shares of one of these "exempt-bond" mutual funds and, as in other mutual funds, gaining the advantages of a large pool of capi­tal, diversification, and skill in selection of bonds by the fund managers. This plan is not a tax dodge, for an indi­vidual shareholder in one of these funds would be in the same tax position as if he bought tax-exempt bonds direct From a broad social viewpoint, it is easy to find reasons why there should be no tax-exempt bonds; but as long as the law allows them, in large and growing quantities, why shouldn't they be made practically available to an investor with little capital?

At present we suggest that before buying bonds to obtain tax exemption, an investor should make sure he understands the A B C's of the bond market. The price of a bond depends more on the number of years to maturity, the credit standing of the borrower, and other technical points than on whether the bond is tax-exempt. We suspect that the advantage of tax-exempts is generally overrated by people who are in­fluenced more by words than by study of net dollar results with these bonds, as compared to other possible investments.

An important thing to consider when looking at free tax advice is that some investments, although not labeled tax-exempt, may cause far less income-tax liability than others do. On an E bond issued by the U. S. Government, income takes the form of a semi-annual rise in the value of the bond. The govern­ment pays this income only when a bond is cashed, and a bond-owner can elect to wait for this cashing before he pays income tax. So the tax to be paid on an E bond is something of a gamble, depending on when the bond is cashed. On E bonds issued before February 1957, the government ex­tended the original maturity by ten years, making a total of almost twenty years that a bond can be held before any income tax is due. Whether a similar extension will be made on the newer bonds is not clear.

The tax delay on E bonds is especially attractive to a middle-aged man who is paying income tax at a rather high rate. He can buy the bonds now, expecting that before they mature, his retirement from earning an income will cut or eliminate his income tax. Or if he dies, his estate will not have to pay tax on the appreciation accumulated during his lifetime. Thus under some conditions, an E bond can be as free of income tax as a bond labeled tax-exempt. And even though the amount of tax eventually paid on an E bond is the same as if paid each year as the bond's value appreciates, still the mere delay can be an advantage. We return to this point later on.

Life insurance is partly exempt from income tax, and on most policies a large portion of the premium goes to build up what an optimist might call an investment. This is one of those situations wherein a buyer, with his attention centered on tax saving, may forget that regardless of tax avoidance, the policy is a lousy investment. The only way a man can get good investment results out of life insurance is for him to die soon enough after starting to pay premiums so that the sum of what he pays in, plus interest on those payments, is smaller than the death settlement to his beneficiary.

Consider this for free tax advice: among pension plans, Federal Social Security is about two thirds income-tax-exempt. In other pension programs, pro­vided they conform to Federal Government regulations, the money an employer contributes to the fund is income tax-exempt, and so is the income the fund receives from its in­vestments, as long as the money remains in the fund; and that is apt to be a good many years. In principle, with this advantage, a pension fund should produce considerably larger pension benefits than an employee could obtain by personal saving and investing. But it seems that pension funds custom­arily are not put into the control of able investment managers, and anyhow, pension benefits are figured on the assumption that the fund's income from investments will be only about 2 per cent a year. Also, many pension plans have farcical results for an employee who does not comply with all the rules, including keeping alive and staying with the same company until he actually retires. So for several reasons a pension fund, in spite of its tax avoidance, may not give an employee and his dependents as good results as he could obtain with a personal fund, provided he is able to save money voluntarily and knows how to invest well.

Owning a home causes an automatic reduction in taxable income. Suppose an investor gets tired of paying rent and decides to buy a home. To pay for the house, if he sells other investments, he loses the income on those investments; he receives no income from the house, and so his taxable income goes down.

Instead of selling something else, suppose he finances the buying of a house by borrowing on a mortgage or other­wise. In that case his gross income does not drop, but he can deduct the interest charges he pays, so his taxable income is lowered. Thus, no matter whether a home is financed by the owner's own capital or whether he borrows, Uncle Sam favors an owner over a renter.

In selecting a stock to buy outside of investment com­panies, a tax-conscious investor needs to remember that how much tax he will incur depends largely on what the issuing corporation does with its profits. The larger the portion of profits paid out as dividends, the more income tax a stock­holder must pay. Contrariwise, the more of its profits a com­pany reinvests in improving or expanding the business, the less tax a stockholder pays.

When it comes to selling stock, the situation is reversed. In principle, at least, a stock that has been paying smaller dividends should experience a greater increase in price, re­sulting in a larger capital gain for a stockholder who sells. But the income-tax rate on capital gains is less than on income dividends, especially for a stockholder whose income is large. So a selling stockholder pays less total income tax on this stock than he would on a stock that paid a larger dividend and showed less capital gain.

Investment companies, in selecting common stocks for their portfolios, vary greatly in the degree of emphasis they place on income as compared to growth in value per share. So between two mutual funds with equally good over-all per­formance, the difference in the rate of income dividends and the consequent difference in a stockholder's income-tax bill can be substantial.

Mutual funds differ also in how freely they sell stock from their portfolios and substitute stock of other companies. When stock prices are higher than formerly and a fund sells considerable stock from its portfolio, this causes the fund to have large capital gains, and the fund is legally obliged to pass these on as capital-gain dividends to its stockholders. Some funds pay capital-gain dividends at a rate several times as high as other funds. On these, the same as with a capital gain from a sale of stock, a shareholder pays a considerably lower rate of income tax than on income dividends. Still, from a tax viewpoint, the best mutual fund is one with low payout on both income and capital gain dividends.

Avoiding a Sale

As long as our cost of living and standard of living con­tinue their long-term tendency to rise, the price of typical common stock is also pretty likely to go up; and if stock is sold after being owned for several years, probably the sell­er will have a capital-gain tax to pay. Obviously a simple way to hold down income tax is not to sell stock when the price per share is higher than the owner's cost!

A man may believe he can get better results per dollar invested by selling one stock and buying another. But a pre­liminary calculation tells him that if he sells, his capital-gain tax resulting from the sale will cut his capital enough so that he will be no better off, perhaps worse off, with the new stock. In Wall Street jargon, he is "locked in" to the old stock. The higher a man's top tax bracket, up to the 50 per cent level, the easier it is for him to get locked in. Thus in Wall Street, sometimes a large income is quite a handi­cap!

This threat that the tax will spoil a sale is a reason why an investor, before buying stock, should choose the company carefully enough so that he is unlikely to want to sell out of that company, at least not for many years.

Of course, putting off a tax liability until a later year sometimes can result in a man's eventually paying a larger tax. Maybe the government will raise the rates or stiffen the rules; or maybe his income will rise.When considering free tax advice it is important to remember that even though a man's earned income is stable, a successful investment program can mean a substantial rise in total taxable income, up to the time when earned income stops.

When a man's tax rate is not rising rapidly, a mere delay in his payment of a tax can be an advantage. This chapter mentions several situations wherein a taxpayer can delay a tax liability by putting off the cashing or sale of an invest­ment. Suppose he delays a tax liability for twelve years, and the return on his capital, including both income and increase in value, averages 6 per cent a year. In twelve years, at 6 percent compounded, an investment will double its value. Looking at the same fact in reverse, delaying a bill for twelve years is equivalent to cutting the amount of the bill in half. And even if he expects his tax rate to rise, but not as fast as 6 per cent a year, a delay in tax payment may be an advantage.

A simple way to accomplish a pronounced reduction in the tax on income from investments is to arrive at sixty-five years of age and to stop earning an income. Several tax rules have a bearing on this situation. It is the combina­tion of all these rules, together with the drop in earned in­come that causes such a cut in income tax.

But none of these rules about reaching age sixty-five and retiring have anything to say about income from investments, so why mention them here? The answer is, look at their indirect effect. Suppose that before a man reaches age sixty-five and retires, he and his wife have a taxable income of $11,000. Their income-tax bill is perhaps 18 per cent of their total income. After sixty-five and retirement, this cou­ple's total income, including pensions, is $8,000, but their taxable income is only $1,700, and dividend and retirement credits cut their income tax still further. Their income tax is only about 2 per cent of their total income, including in­vestments.

Several years before retirement, perhaps a man can take advantage of the tax concessions just mentioned by delaying the cashing or the sale of an investment until after he retires.

Still another way to reduce income taxes is to make gifts. A gift to a relative or friend reduces the donor's tax bill simply by lowering his income. On a gift to a charitable or educational institution, he can subtract the value of the gift from his taxable income, and for one form of gift, he need not reduce his total income!

Finally, an investor's death can cancel some of his tax potentials. Suppose a man owns corporate stock whose mar­ket value is much higher than it cost him. If he sells, he has a big, taxable gain. But if he still owns the stock when he dies, then for his estate, the cost of the stock is its market value at the time of his death. The gain in value of the stock during his lifetime is forgotten, as far as income tax is concerned. Of course, some investors may prefer to stay alive rather than for their heirs to gain this tax concession!

In the meantime, while reading this chapter on free tax advice, don't let yourself drift into the notion that cutting income taxes is a goal in itself. An intelligent investor aims at first-class in­vestment results, and too much attention to tax avoidance may blunt his aim.