FOOLISH FOUR PORTFOLIO

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Tax Implication
How does the Fool 4 stack up?

by Ann Coleman (TMF AnnC)

Reston, VA (May 19, 1999) -- Do taxes really negate the market-beating performance of the Foolish Four? Well, first things first: Is everyone maxed out on their tax-advantaged IRAs, Roth IRAs, 401(k)s, 403(b)s, SEP-IRA, Keogh Plans, and secret accounts on Grand Cayman Island?

Just kidding about that last one.

Make no mistake. Without the shelter of a retirement account, the Foolish Four strategy will create those lovable "taxable events" with calendar-like regularity. If all of your investing is done within the confines of the various tax-advantaged retirement accounts, that is not a big concern, but for those fortunate enough to be fully invested in those options with money left over, or to be earning the big bucks that make them ineligible, the tax implications of a strategy that calls for yearly trading do need to be understood and compared carefully with the alternatives.

First, though, there is one aspect of the traditional retirement accounts (i.e., all of them except the Roth) that you should understand. They have a nasty little secret. Withdrawals from these accounts are taxed at regular income tax rates. Now, if you are socking your retirement cash away in a CD or maybe some utility stocks, that doesn't matter much, because interest and dividends are taxed at the same rate as regular income. (You won't be paying that much in tax anyway, most likely, because your account isn't going to grow very fast. Really, you would rather be paying more in taxes, but that's another issue.)

If your retirement account is invested in stocks, though, a good portion of the cash you withdraw in your golden years is going to have come from capital gains, which outside of retirement accounts, are taxed at a lower rate than regular income. There's the rub. I suspect much wailing and gnashing of teeth as this becomes obvious now that the capital gains tax has been reduced. There is certainly a fundamental unfairness here. Maybe Congress will even rethink the way that traditional retirement accounts are taxed. But we can't count on that.

Here's how taxes impact your Foolish Four account:

1. Roth IRA -- No impact at all. You get to keep whatever your investments earn and even pass it along to your heirs without paying any final income tax (although estate taxes still apply). The Roth is funded with after-tax dollars -- no tax deduction for the contributions.

2. Other retirement accounts: You will pay taxes on your withdrawals (including a final withdrawal to your heirs) as though the money were "earned income" from a job. If the money you contributed wasn't taken as a tax deduction, that cash can come out tax-free, but I hope you converted those contributions to a Roth last year if you had them.

3. Regular accounts: Every time you sell your Foolish Four stocks for more than you paid for them, you will pay taxes at prevailing capital gains rates. Dividends will be taxed at "earned income" rates.

Alternatives

This is what really matters. Are there better alternatives?

To the Roth? No. If you qualify, take advantage of it for all you're worth.

To traditional retirement accounts? Maybe.

The traditional retirement accounts let you put off paying taxes until you withdraw the money. This lets your account grow much faster than if you were shipping some of your gains to Uncle Sam each year. (See Foolish Four Daily, 04/08/99: The Impact of Taxes.) If you are comparing a Foolish Four strategy inside a traditional account with one outside, the retirement account comes out ahead. Even though you eventually pay a higher rate on the withdrawals than you would pay yearly on capital gains, you can afford to do that and still come out ahead, because your tax-sheltered account grows so much faster.

However, a buy-and-hold strategy, such as an index fund, Spiders or Diamonds, or even just buying Coca-Cola (NYSE: KO) or Microsoft (NYSE: MSFT) or WalMart (NYSE: WMT) or Berkshire Hathaway (NYSE: BRK.A) or [insert your favorite long term winning stock here], has a built-in tax advantage. As long as you don't sell, no taxes are due on the capital gains. If you imagine two accounts, a Foolish Four account inside a traditional IRA vs. a buy-and-hold account outside an IRA, both started with the same amount of money and growing at the same average annual rate, the buy-and-hold account can put more money in your pocket.

Here's how it works (ignoring dividends and simplifying a lot): Both accounts grow at the same rate because, as long as you don't sell the stocks in your buy-and-hold account, neither has any tax liability. Thirty years later, you retire and, wonder of wonders, the tax code hasn't changed. Each year you take $50,000 out of each account, selling stocks as needed. The withdrawals from your tax-sheltered account are taxed at 28% (or higher), while the withdrawals from your buy-and-hold account are taxed at 20%. The buy-and-hold account puts $40,000 a year after taxes into your pocket, while the retirement account puts only $36,000 into your pocket.

The trick is finding a stock that you can buy and hold for the next 30 years that will perform as well as we expect the Foolish Four to do. Without a bit of hindsight, such stocks are not so easy to find. A good place to look for them, though, is in our Rule Maker Portfolio.

Now let's forget about tax-advantaged accounts and look strictly at the impact of paying annual capital gains taxes vs. a buy-and-hold strategy. In this case, the alternative postulated by McQueen and Thorley in the article we have been discussing for the last week and a half is an index investment like Spiders or Diamonds. Those are guaranteed to provide you with "market returns" because they are the market.

Unlike risk adjustment, we can't dismiss the effect of taxes. In a non-tax-sheltered account, you must always take taxes into consideration. If you can't beat the market after taxes, then go for the index investment.

Of course, we have no guarantee that the Foolish Four strategy will outperform the market in the future like it has in the past. At the high rates of return that we have seen in the past, it's quite easy to demonstrate that the Foolish Four will easily beat an indexed investment even when you're paying higher commissions and taxes. For me, the real question is, how much leeway is there? How much can the Foolish Four slip and still beat an index fund?

For the last 25 years, both the Dow and the Standard & Poor's 500 Index have returned within one-tenth of one percent of 15% on average each year. Over this same time period, our original Foolish Four returned an average of 23.0%, and the current version averaged 24.5%. The High Yield 10, the lowest-performing and safest Dow investing strategy, averaged 18%. So I ran the numbers comparing an index investment that pays NO taxes with an underperforming Foolish Four account that pays 22% in taxes on each year's gains (the extra 2% is because some of the gains will be in the form of dividends, which are taxed at a higher rate). I also deducted transaction costs of $100 per year from the Foolish Four account.

The breakeven point was a hair over 18%. So the Foolish Four could revert to being no better than the High Yield 10 and you would still come out ahead in a taxable account.

By the way, this exercise gave the indexed investment ALL the breaks and some that it would not get. I decided to not tax it at all because there were so many different ways that the taxes could be applied: For example, all at once after 25 years -- the breakeven point for that scenario was 17%, but most people wouldn't be liquidating an account at one time like that. If you simply sold off X amount per year, the account would continue its buy-and-hold advantage. Rather than run zillions of scenarios, I just stacked the deck against the Foolish Four to see what would happen.

Even handicapped and limping, the Foolish Four looks pretty good.

Fool on and prosper!


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Today's Stock Lists | 1999 Dow Returns

05/19/99 Close
Stock  Change   Last
--------------------
CAT  -  11/16  58.00
JPM  +2  1/8   138.75
MMM  +1  5/16  89.38
IP   +1  3/8   54.00
                Day   Month    Year   History
        FOOL-4   +1.01%  -1.85%  26.56%  28.44%
        DJIA     +0.47%   0.91%  18.97%  18.49%
        S&P 500  +0.82%   0.68%   9.67%   9.94%
        NASDAQ   +0.74%   1.36%  17.55%  19.16%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     58.00    34.63%
 12/24/98    9 JP Morgan    105.51    138.75    31.50%
 12/24/98   22 Int'l Paper   43.55     54.00    24.00%
 12/24/98   14 3M            73.57     89.38    21.48%


    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1392.00   $358.00
 12/24/98    9 JP Morgan    949.62   1248.75   $299.13
 12/24/98   22 Int'l Paper  958.12   1188.00   $229.88
 12/24/98   14 3M          1030.00   1251.25   $221.25

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5137.71