A Tax-Smart Investment Option: Individual stocks

Individual stocks

President Bush's 2003 tax cut made it much easier to construct a more diversified portfolio with a low tax impact. The cut drove the top federal capital-gains rate down to 15% and made the same rate apply to dividends issued by domestic stocks and mutual funds.

But if your taxable income puts you in the 10% or 15% bracket (that's $65,100 for married filing jointly in 2008, half that for singles), your capital gains and dividends rates is zero, at least from 2008 to 2010. (In 2007, you owe only 5%.)

That means you can add value stocks to your growth selections without major suffering at tax time. You can rebalance occasionally and, as long as you've held the stocks at least a year, benefit from a lower capital gains rate. Personal finance software such as Money or Quicken can help you identify the best combination of securities to sell to minimize taxes.

If you want to round out your portfolio, you can invest in municipal bonds, which pay tax-free interest, and tax-free money market accounts. (Corporate bonds, particularly the high-yield variety, are better off in tax-advantaged accounts, because their interest is taxed at income tax rates.)

Another investment to consider: preferred stocks, which typically pay rather generous dividends on a set schedule. These issues aren't like traditional stocks, in that they represent a debt contract rather than a piece of ownership in the company. So you don't get to benefit from any rise in the company's value, but you do get a bond-like income stream.

But owning preferred stocks, or individual stocks of any kind, isn't for everybody. Individual issues are riskier than diversified mutual funds, and they require a lot more research and monitoring. You need to pay attention to the news and other events that affect your stocks, and have a sell strategy for each. (The days of buy and hold forever are pretty much gone for good in this fast-changing global economy.) It's also tough to get properly diversified. Some financial planners believe you need a portfolio of $250,000 or more to achieve true diversification.

You should know, too, that payouts from foreign stocks and real estate investment trusts don't qualify for the dividend tax break. For maximum tax efficiency, these investments should be held in tax-advantaged retirement accounts.