Drip Portfolio A Sweet Capital Gains Tax Twist
The new five-year holding tax rate is low, low, low

Beginning this year, investors can look forward to reduced tax rates for super-long-term holdings. Any stock that you buy after January 1, 2001 and hold for at least five years will now be subject to new, very low, "super-long-term" tax rates. This gives Fools yet another reason to buy and hold great companies for at least five years.

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By Vince Hanks (TMF Elwood)
February 6, 2001

Looking for a tax break? Registration for The Motley Fool's "Give Yourself a Tax Cut" online seminar closes today, February 6th. You can still join the seminar today to learn what you need to know about taxes and investing, and to learn how to get more from your tax return.

Looking for another tax break? The ever-changing capital gains tax laws have a new twist in 2001 that may qualify you for a super-reduced capital gains tax rate.

Up until now, there were only two holding periods. Short-term holdings are those, like most Hollywood marriages, that last one year or less. Long-term holdings are investments you've held for greater than one year. To encourage investors to keep their green in the market for longer periods of time, long-term holdings receive special capital gains tax rates. So far, the government hasn't taken steps to aid Hollywood marriages.

The long and short of it
The argument for holding investments for greater than one year is pretty convincing. Consider the difference in tax rates for long vs. short:

Short-term holdings sold for a gain are taxed at your normal income tax rate. This is anywhere from 15%, for those in the 15% tax bracket, or 28% to 39.6% for those in a tax bracket greater than 15%.

Long-term holdings sold for a gain are taxed at a reduced rate. For those in the 15% tax bracket, the rate is 10%. For those in a tax bracket greater than 15%, the rate maxes out at 20%.

You can see how holding on for at least a year can reduce the slice the government carves out by nearly 50%. The new rules can reduce that rate even more.

Super-long-term holdings
Beginning on January 1, 2001, a new super-long-term holding period came into effect. Investments purchased after January 1, 2001 and held for five years or more will be considered super-long-term holdings. (If you're in the 15% tax bracket, any investments held for more than five years qualify for the super-long-term rate, regardless of purchase date.) Investments sold for a gain at a super-long-term holding rate will be taxed at the super-reduced rate of 8% for those in the 15% tax bracket, and 18% for those in tax brackets above 15%.

Just super. Well, except that little part about needing to buy after January 1, 2001 if you are in a tax bracket above 15%. Any holdings purchased prior to January of this year are considered just normal long-term holdings whether you've had them just over a year or 25 years, and whether you sell them this year or in the year 2080, say.

There is a way, however, to convert your current holdings to the new super-long-term variety. But, it comes at a price.

You see, the government feels for us. It wants us to be able to take advantage of this new super-reduced rate. Er... well, it sort of feels for us. If you want to convert any holdings from 2000 or prior, you can pretend that you sold and purchased them back on January 2, 2001 at the same price, and pay the appropriate amount of capital gains tax one year from April on your 2001 income tax return.

I'm not kidding. By designating those investments as being sold and bought-back on January 2, and paying the taxes on gains from that sale, you can consider them super-long-term after January 2, 2006. Of course, this assumes the laws don't change again in the meantime.

If this sounds like a route you'd like to travel, you have until you file taxes for 2001 to make that designation. The date of the sale and subsequent buy-back has to be marked as January 2, 2001, however.

I suggest that, in most cases, it wouldn't be prudent to convert existing holdings to the super-long-term variety. Paying 10% to 20% or more off the top in current taxes just to save (probably) 2% down the road probably won't work out in your favor. Converting small, recent Drip purchases to the super-long-term tax rate may make more sense, however, so you might want to think about that. You could be rewarded for doing this when you finally do sell your shares some time after 2005.

The most important takeaway from the new law is this: Every stock that you purchase after January 1, 2001 is now eligible for the super-long-term holdings tax treatment, giving you even more incentive to purchase great companies that you can hold for at least five years.

For more information on capital gains straight from the horse's mouth, see the IRS publication on the issue. For Foolishly understandable information regarding capital gains and losses, see the Fool's All About Taxes area.

Vince Hanks is a full-time pharmacist in Michigan as well as a Drippin' Fool. To see the stocks he owns, view his profile. The Motley Fool is investors writing for investors.

Drip Portfolio


2/6/01 as of ~8:30:00 PM EST

Ticker Company Price
Change
Daily Price
% Change
Price
CPBCAMPBELL SOUP(0.26)(0.81%)31.70
INTCINTEL CORP0.752.16%35.44
JNJJOHNSON & JOHNSON(0.51)(0.54%)93.42
MELMELLON FINANCIAL CORP(0.99)(2.07%)46.76
PEPPEPSICO INC0.290.64%45.26

Overall Return -- total % Gained (Lost)
  Day Week Month Year
To Date
Since
Inception
(7/28/1997)
Drip(0.11%)(0.76%)(1.25%)(0.84%)24.34%
Comparable S&P 500n/an/an/an/a16.22%
S&P 500(0.15%)0.21%(1.01%)2.42%44.04%
S&P 500 (DA)(0.15%)0.20%(0.99%)2.38%46.67%
NASDAQ0.81%0.15%(3.90%)7.85%69.76%

Internal Rate of Return -- Annualized Rate of % Gained (Lost)
  Since Inception (7/28/1997)
Drip11.12%
vs. S&P 5007.71%

Trade Date # Shares Ticker Cost/Share Price Total % Ret
9/8/9752.2886INTC24.8935.4442.90%
10/7/9837.4877MEL34.8346.7637.48%
11/14/9716.289JNJ80.1793.4219.16%
7/28/007.1501PEP47.6745.26(4.81%)
4/13/988.465CPB53.8131.70(37.50%)

Trade Date # Shares Ticker Total Cost Current Value Total Gain
9/8/9752.2886INTC$1,301.42$1,852.98$558.28
10/7/9837.4877MEL$1,305.64$1,752.92$489.36
11/14/9716.289JNJ$1,305.89$1,521.72$250.25
7/28/007.1501PEP$340.86$323.61($16.39)
4/13/988.465CPB$455.50$268.34($170.81)
 
Cash: 
Total: 
$0.02
$5,719.60
 


Key
• S&P 500 (DA) = dividend adjusted. Dividends have been added to the total return of the index.

Note
Drip Port launched with $500 on July 28, 1997, adds $100 to invest every month, and the goal is to own $150,000 in stock by August of the year 2017. Due to the slow nature of dollar-cost-averaging and our relatively significant starting costs, we do not expect to seriously challenge the S&P 500 for the first three to five years as we build an investment base. The long-term advantages of dollar-cost-averaging still overcome the short-term disadvantages, however. Final note: our investment in Campbell Soup is frozen due to fees instituted in its investment plan. Click here for a history of all Drip Port transactions.