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Will This Start the Next Bear Market?

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Like it or not, taxes play an important role in smart investing decisions. Now that an important anniversary is upon us, some tax-minded investors can now start looking to take profits -- which could put an end to the yearlong rally in the stock market.

Cashing in
The past year has been simply amazing for stock investors. This time last year, many seemed convinced that the financial crisis would blossom into a second Great Depression. Uncertainties about everything from the ability of businesses to access the credit markets to the continuing viability of money market mutual funds had most people completely spooked about the future of the financial markets. It took nerves of steel to buck the doom and gloom and put your cash to work buying stocks.

Fast-forward to today, though, and it's almost as if that terrible episode in financial history has been completely forgotten. Economically, things are far from perfect, as high unemployment continues to put a damper on consumer confidence. But rather than seeing nothing but dramatic losses throughout their investment portfolios, many investors now have gains to protect -- and they want to do so in the most tax-efficient way possible.

The rewards of patience
Given just how massive some of those gains are, you might think that trying to save on taxes is just being greedy. But the very magnitude of investors' profits has made it that much more important to pay attention to the impact that taxes have. And the fact that even well-known large-cap companies have seen impressive rises in their share value means that millions of investors are in the enviable position of having big gainers in their portfolios -- and potentially owing a whole lot of tax as a result.

All it takes to save a lot of money is a little patience. Consider, for instance, just how much waiting could save investors in these stocks:

Stock

1-Year Return

Potential Tax Savings on $10,000 Investment If Held Longer Than 1 Year

American Express (NYSE: AXP  )

284.8%

$5,696

Bank of America (NYSE: BAC  )

347.6%

$6,952

Ford Motor (NYSE: F  )

643.1%

$12,862

Coach (NYSE: COH  )

223.1%

$4,462

Teck Resources (NYSE: TCK  )

1310.5%

$26,210

Dow Chemical (NYSE: DOW  )

383.6%

$7,672

International Paper (NYSE: IP  )

476.5%

$9,530

Source: Yahoo! Finance. Tax savings assumes short-term gains rate of 35% and long-term maximum rate of 15% apply.

Simply by waiting more than a year to sell, you may be able to cut your taxes by more than half. For stocks that rose 500% or more, that means that your tax savings might actually be more than what you initially invested in your stocks.

Pent-up selling
Of course, there's a risk to holding onto your shares for tax purposes: If the stock drops, it could cost you more in lost profits than you'd gain from lower taxes. But if you've already held onto your shares throughout much of the rally, then you're pretty close to the one-year mark, and so you might conclude that holding out for another month or two might be a smart move.

One concern this raises, though, is the fact that if everyone's looking to sell in the near future, it could bring about the long-awaited correction that many have been looking for. Typically, you see a similar phenomenon with losing stocks toward the end of the year, when investors use the technique of tax-loss harvesting to gather tax breaks from losing stocks. Often, the massive selling results in shares falling still lower in November and December, when everyone's trying to get last-minute tax breaks.

In this case, though, I think there's less reason to fear a crash. For one thing, investors still have to pay some tax if they sell their shares, and many would prefer to hold on in the hopes of even greater gains in the future.

Moreover, unlike with tax-loss selling, different investors will hit the one-year mark at different times. That will spread out any selling pressure, making it less likely that there'll be a cataclysmic crash in these stocks.

Most importantly, though, the lack of attractive alternatives will likely discourage shareholders from selling out now. With safer investments paying very little in income, you're more likely to see wary investors doing some minor rebalancing rather than selling their winning stock positions outright.

Be tax smart
It's always nice to see big profits on your investments. It's important, though, to make sure you don't pay more in taxes than you have to. By keeping an eye on the IRS, you can make sure you'll keep as much of your profits as you can.

Be sure to check out the Motley Fool's Tax Center for the latest on how to keep more of your money and pay less to the IRS.

Fool contributor Dan Caplinger does his best to avoid taxing situations. He doesn't own shares of the companies mentioned in this article. American Express is a Motley Fool Inside Value recommendation. Coach and Ford Motor are Motley Fool Stock Advisor selections. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy loves to stop at the duty-free shop.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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