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Lots of people will do almost everything to avoid having to pay more taxes to Uncle Sam. But just because you want to protect your money from the IRS doesn't mean you should make boneheaded moves with your investments.
Pay now to save later
A recent article in Barron's highlights a problem that many people are struggling with: the possibility of higher taxes in 2011 and beyond. With tax cuts due to expire and everything hanging on a lame-duck Congress to fix the problem, some investors have simply decided to bank on higher tax rates coming back next year.
When tax rates are on the rise, taxpayers are in an unusual situation. Usually, it's smarter to put off paying tax as long as you possibly can. But what the Barron's article discussed was selling stocks with big capital gains now in order to lock in this year's 15% maximum tax rate on those gains, rather than potentially having to pay 20% or more next year if you wait to sell until after Dec. 31.
So far, that makes perfect sense: Selling now in the hope of eventually saving 5 percentage points in tax could be a smart move for some folks. What doesn't make sense, though, is the strategy the article suggests after you sell.
Why get complicated?
If your sole purpose is to reap a tax gain, you can simply sell your shares and then buy them right back again. There's no wash-sale rule for gains, so for the cost of a couple stock commissions, you can achieve your goal and end up with exactly the stock exposure that you had before the sale.
What the article suggests, though, is to buy long-term call options rather than repurchasing the stock. The article points to Netflix (Nasdaq: NFLX ) , Apple (Nasdaq: AAPL ) , and priceline.com (Nasdaq: PCLN ) as ideal examples where this trade makes sense.
The problem with the strategy is that it fundamentally changes your investment. Rather than accepting the possibility of a complete loss in exchange for potentially unlimited gain, buying a call option involves paying a substantial sum of money upfront in order to avoid having to have any downside risk at all.
Don't pay for what you don't want
Now with stocks like those, an investment that limits your downside may make sense. Netflix is the first mover with an incredibly promising business model, but competitors Coinstar (Nasdaq: CSTR ) on the physical DVD side of the business and Apple on the streaming side could put a dent in a stock that's priced for a perfect future. Similarly, Apple is riding high on its iPad and iPhone 4, but Google (Nasdaq: GOOG ) Android-based phones are hanging tough, and Research In Motion (Nasdaq: RIMM ) recently announced its PlayBook tablet would be priced competitively with the iPad.
But you pay a lot for that downside protection. The article talks about paying $37.84 per share – more than 20%! -- for Netflix call options expiring in January 2012. Just to break even, you'd need the shares to rise by more than that same $37.84 amount. And if the shares stayed flat, the option strategy would turn what would've been a break-even situation had you held onto your stock into a loss of your entire premium. The only way you end up better off with the call option is if the shares fall.
More importantly, tax strategies shouldn't be the reason for changing your investment strategy. Priceline, for instance, thrashes the competition quarter in and quarter out, while rival Orbitz Worldwide (NYSE: OWW ) has actually seen its stock fall. Why pay a big premium for a call option if you don't believe there's any downside risk to just owning the stock outright?
Keep it simple
Options can be extremely useful tools to match up risk and reward the way you want. But if you're just looking for a way to max out your 15% gains, skip the options and just buy back your shares after you sell them. Sometimes, the simplest way is the best way.
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