Author: A.T.

You are such a tough crowd. Friday, I responded to one of you who was considering participating in his company’s Employee Stock Purchase Plan. His wife thought he shouldn’t do it. But like many such plans, this one offered two incredible things — hindsight (by allowing him to purchase shares in his company’s stock at the lower of the current price or the price six months earlier); and free money (by giving him yet a further 15% discount off that price). In other words, worst case, he’d have an instant 15% gain on the shares.

“So, what do you think?” he asked me. “Am I better off staying out of the plan as my wife thinks or am I stupid not to be investing to the hilt, as my co-workers say?”

“Well, I wouldn’t use the word stupid,” I replied, not wishing to offend. “But it does sound like a very good deal.”

Several of you thought I was being much too polite.

Dan H.:

Well, I’d use the word “stupid.”

You hit a pet peeve: people who don’t enroll in their ESPP programs because they think they can’t afford it.

The plan that your correspondent describes is pretty typical for those of us that work in the high tech field. Consider the ROI [return on investment] of investing in the aforementioned ESPP. He gets a 15% discount. Ok, so his ROI is 15%. No, wait. He only had the money tied up for six months, so the ROI is 30%. No, wait. He started out with no money invested and in a linear progression invested the full amount over those six months. On average, he only had half of the money invested for those six months, so the ROI on his investment is really 60%!! [No wait. If you do it on an annualized basis using the IRR function of your calculator or Excel spreadsheet, it comes to more like 93%.] What other investment guarantees you 60% [let alone 93%] ROI with no risk??

If he’s concerned about the market volatility, he can always short the shares on the day the ESPP period ends (assuming that he has a margin account) and then deliver up the shares to close the position when he actually gets them.

If liquidity is the issue, he should take note that one is better off borrowing against a credit card at 21.5% and enrolling in the ESPP program rather than not participating in the program!!

If his concern is brokerage fees, then open an Ameritrade account and pay the $8.

Furthermore, if he holds the shares for 1 year after their receipt and 2 years from the enrollment date for the ESPP, then they qualify for long-term capital gains treatment and only the 15% discount is taxed at the ordinary rate. You may even be able to get away with deferring the payment of taxes on that 15% discount until you sell, depending upon the position that your employer takes with the IRS. (They, being the IRS, argue that the tax is due now. Some high-tech employers argue that is not the case.)

Oh yeah, and don’t forget the considerable upside possibility that Sun Microsystems stock may continue to skyrocket during those 6 months [so the 15% guaranteed gain — which is really a 93% rate of return — might actually be a great deal higher]. How else can you invest in a tech stock without personally assuming any risk of loss?

Just sign up.

Brian Holdren explains very clearly how that minimum 15% turns out to be 93%:

I use the following example to try to persuade people that it is foolish not to participate in these plans. [Ah — foolish! That’s a lot less offensive than stupid. Brian is a diplomat after my own heart.] Assume you contribute $100 per pay period (twice a month in this example). At the end of 6 months you have put in $1200. You get a 15% discount on the stock when you buy it, so you’re able to buy $1411.76 worth of stock for only $1200. (This assumes that the stock price has not risen over the 6-month period.) But, not all of your $1200 dollars has been tied up for the full 6 months. In fact, less than half of it has been. Try to figure out what interest rate you’d need from your local bank to turn those $100 twice-monthly deposits into $1411.76 after only 6 months. Input the 12 biweekly payments into Excel, and it will tell you: 93%. The annualized return comes from Excel’s XIRR function (Internal Rate of Return).

Of course, not all plans are equally good, so it’s important to understand the rules . . .

Clint Chaplin: “I had to interject something: Some companies will not allow you to flip the stock when you purchase it; they require a six month holding period, in which time the stock could go south on you.”

And not everyone is enamoured with them . . .

Toby G: “I have had experience with these also. I was in one for several years and eventually came out of it just about even. That came from holding on to the shares. I then swore off of such plans for life. [I have withheld Toby’s last name here in order to be able to say it’s really . . . foolish . . . to swear off these plans, let alone swear them off for life.] A more important point about your article today: a company I worked for recently also had such a plan. But their policy was that employees were not permitted to short the stock or to trade in options at all. So, if you were in the plan you were vulnerable to short-term losses if they occurred when you were buying shares. And it did happen, and not just in October 1987. They did make one adjustment to ease this, though: they moved the plan dates to mid-quarter instead of coinciding with the ends of the 2nd and 4th quarters, since the greatest volatility occurred in association with reporting quarterly results.”

Plans do differ . . .

David D’Antonio: “I read your comment today about Employee Stock Purchase Plans and I was rather taken aback that it took this person 2-3 WEEKS to get his shares. The company I work for has about a 2-3 DAY delay due to much of the work being done by hand. But I still could sell on the day the shares were posted to the account.”

David goes on to make a separate point: “There is another way to get burned, as some people have here. Namely: black-out periods [during which you are not allowed to buy or sell shares]. The ESPP buy dates used to coincide with a company-wide black-out due to earnings announcements. When the black-out period expired, the stock was often lower than the buy price. But that’s been fixed by shifting the ESPP buy dates. And then they removed the black-out period for all employees under the Director level so it’s doubly moot for most of us.”

But by and large, as I tried to suggest Friday, Employee Stock Purchase Plans are generally a very good deal. Let’s give the last word to ddg (who prefers to be identified only by his initials):

Uh, oh, Andy you blew it today. Your advice was below par, not what I expect from you.

His company is offering him 17.6% free!

[If you get $100 of stock for $85, you’re getting a 15% discount. But your $85 has instantly appreciated 17.6%. And as noted above, the actual internal rate of return comes to more like 93%. And all this presupposes that the stock has not risen during the six-month period. The actual discount could be much higher than 15%.]

Should he take the free money? The answer is: It is stupid not to. [Stupid! Cretin-like! Dumb as mud!]

The deeper question is: should he sell the shares immediately? His wife’s complaint that he “has no money to invest” is inexcusable [inexcusably stupid!]. If he has a steady income, he must set aside a portion to invest, and you should have emphasized that. It will never be easier to start in the future. The part that gets easier is the amount, not the initial habit.

So my advice would have been to squeeze your finances for whatever you can. Eat hotdogs, or rice and beans, or maybe even fast one day a week. Whatever. Start payroll deducting as much of the $4000 as you can. If you can’t do it all this year, add 50% of your next raise, and 50% of the next one until you do get to the “hilt.” (Like I said, it does get easier.)

When you get the shares, you will pay taxes on the 15% company contribution, but you won’t have brokerage fees unless you sell. If you absolutely must have some of the money back, then sell what you must. But just as you squeezed to get the shares, you should hold them, too. As long as you believe in your company’s growth, then you should take the opportunity to own part of it. If you don’t believe your company is worth investing money in, then you have a bigger problem — you shouldn’t want to invest your time there either.

[DDG may be getting a little carried away here. It’s not easy to hop jobs every time you think your company stock is overvalued, or less attractive than others. And you already have a huge egg in the company basket — your livelihood. Think twice before putting too large a portion of your net worth in the same basket.]

Brian must form these habits now.

I’ve “been there, done that,” and over my wife’s initial objections, too. She’s a lot more comfortable with it now, particularly since the investment is worth 8 times my total contribution.

Please use only my initials if you print this. — David D. Godfrey

Needless to say, all this works better when stocks are generally rising than falling. But over the very long run, stocks generally do rise. And, in any event, if your plan allows you to lock in your 17.6% profit instantly, with no risk of loss, it’s stupid not to take advantage of it. There. I said it.

(Needless to say, also, I’m kidding about David D. Godfrey. Ddg’s real name is . . . well, I can’t tell you.)

Mike Asato: “I am told that options and futures are taxed differently from stocks and bonds. If that is true, are LEAPS (Long-term Equity Anticipation Securities) — options with two to three year time-to-expiration periods — taxed like conventional options? How long can capital losses that could offset capital gains be carried forward?”

With options, the tax treatment is tricky only if you exercise them. Otherwise, you just treat your profit or loss like any other. With LEAPs held more than a year, gains get the favorable long-term gains treatment.

(If you do exercise an option, there is no tax due at that time. Rather, the cost of the option is added to the cost of exercising it, and that becomes the “basis” of your holding. When you eventualy sell, the gain or loss is calculated accordingly.)

But you’re right: futures (also referred to as “commodities”) are taxed specially. Futures are marked-to-market at year-end and assumed to be 40% short-term, 60% long-term, no matter how long you’ve held your position.

I realize that may sound dense to someone who doesn’t know much about this, but I have no interest in explaining it because if you speculate in futures, you will lose your money. So forget it.

As to the last part of your question — “How long can capital losses that could offset capital gains be carried forward?” — this isn’t really important, counsels my wise friend Less Antman, “since a person who trades extensively in options will never have any capital gains.” However, you can carry your losses forward indefinitely. Or, as Less puts it, “The carry-forward of unused net capital losses has no expiration date, except for the expiration of the investor.”

Brian Utterback: “One thing your book does not mention is Employee Stock Purchase Plans. I am sure you know about these types of plans, where there is a payroll deduction throughout a 6 month period, then at the end of the period the money is used to purchase the company stock at a 15% discount on the lesser of the price of the stock on the first and last day of the period. So theoretically, the worst case scenario is that you could sell the stock immediately for a 15% profit, possibly much more if the stock has gone up over the 6 months.

“Unfortunately, it is possible to lose money, as I once discovered. It takes 2-3 weeks to get the shares, during which time the stock could go down. And that is what it did to me. It went down 25% in 3 weeks, after having gone down about 5% over the 6 months. That was in October of 1987. While this is unusual, it has happened to several of my friends as well.

“The company I work for is Sun Microsystems, which has had extremely good performance of late; I believe this will continue as I have a lot of faith in it. If I had enrolled in the plan for just the one 6-month period 2 years ago when I started here, and held the stock until today, I would have made a 425% return.

“My wife does not think this is so worthwhile (she hasn’t read your book). With the brokers fees, and taxes, she feels that the return is too small. We do not have any extra money to invest and have a car loan at 7%. I can contribute up to $4000 during the 6 months.

“So, what do you think? Am I better off staying out of the plan as my wife thinks or am I stupid not to be investing to the hilt, as my co-workers say?”

Well, I wouldn’t use the word “stupid,” but it does sound like a very good deal. And if you’re worried about a repeat of 1987, you could even buy puts to hedge your bet while you wait for the stock to arrive after you pay for it.

I am grateful to Jane Bryant Quinn for forwarding this gem:

STOCKHOLM (Reuters) – A yucca plant is the latest investor on the Stockholm Stock exchange, issuing buy and sell orders on the exchange’s 16 most traded shares.

Swedish artist Ola Pehrson has attached electrodes to the plant’s leaves and, through a sensor, can feel the plant’s growth with movements linked to a computer program tracking the 16 most active stocks. When the yucca’s stock recommendations perform better than the bourse’s general index, it is given water and light. If the plant fails to deliver profits, it stays dry and in the dark. The yucca is part of an exhibition by seven Swedish artists in Stockholm.

But what if you don’t have a yucca plant?

John Wilkerson: “I would like to know by how many percentage points my fund needs to outperform the comparable low-expense funds in order to equal or beat them. Like so many investors, I hope my selected fund will outperform even over time. While this is a questionable assumption, it would still be useful and interesting to have this calculation.”

Good question. If — say — your fund has 4% in costs each year and mine has 1%, then your fund has to somehow make up that 3% difference. So if my fund matches “the market” before considering costs, your fund has to BEAT the market by 3% each year merely to equal mine.

Which is harder than it sounds, because although 3% is “a small number” when it comes to most things — our swimming pool has 3% more water in it after a good rain (who cares?) — it is a HUGE thing when it comes to investments. Over time, investments in “the market” have been expected to grow, between dividends and appreciation, at 9% a year. These days, many of us expect a lot more, but I’m not sure that’s realistic. Anyway, to make the math simple, stick with that 9%. For YOUR fund to grow 3% faster is for it to grow one-third faster. Your guy has to run one-third faster just to keep up with my guy.

Interestingly, the stock market investor who’s run the fastest over the years, Warren Buffett, owes his extraordinary success in no small part to his practice of minimizing taxes. (He also kept his costs ridiculously low — for the longest time, headquarters had a total of six people, including the boss. And those headquarters are not a penthouse suite of offices in Manhattan, they’re a modest affair in … Omaha.) As I have written elsewhere, if he had paid long-term capital gains tax on the growth of his fortune each year, rather than letting it compound year after year, he would have cut his long-term compounded growth from 26% or so to more like 18%. Instead of having $40 billion or whatever he’s worth by now (sorry, no time to look it up), he’d have barely $4 or 5 billion.

Costs make a huge difference. As Buffett’s example proves, a few rare individuals CAN outpace the market by a wide margin and for a long time. But high costs and high turnover are rarely the way they do it.

Which leads me once again to invite you to visit the new Personal Fund site, for those of you who haven’t. We just got a really nice endorsement from the Consumer Federation of America (“invaluable”).

1. Call 1-800-578-7453. This you can do right away, and it will prove to you that the tobacco companies — Brown & Williamson particularly — truly love you.

2. Go see THE INSIDERS, a $70 million Disney effort starring Al Pacino. This you can’t do until November 5, but make a note to. It’s dynamite. It will prove to you that the tobacco companies — Brown & Williamson particularly — may actually deserve the lawsuits raining down on them. (I know, I know — but see it before you tell me I’m wrong about this.)

3. Click here to find the price your neighbor paid for her home. I checked my own home first . . . for which I thought I had paid $120,000 . . . and found that — yes! that’s right! — I had actually paid $105,000. Can you believe that? The Internet could find in seconds something that I — whose life it is after all — couldn’t quite remember. (The asking price was $120,000. I thought I had just decided to pay full price because I liked it so much. With this memory jog, I now remember I offered $100,000 and they came back at $105,000 and then I decided I’d better not haggle.)

Then I tried an apartment on Central Park West in New York and came up with nothing until I reentered it as “West Central Park.” And then I tried a lot of other places and came up with nothing. The service is spotty, to say the least. But it’s still pretty cool.

You know how some people love humanity but not people? Well, with lawyers I’m the reverse. I love them one-on-one; many of my best friends are lawyers. But taken together as a throng . . . well, I’ve long thought we may have too many of them.

Whatever your take on this, I suspect you may find overlawyered.com engaging.

Quoting now directly from the teasers for recent highlights:

• Oops! Calif. Gov. Gray Davis accepts a single eagle feather as a ceremonial token of Indian leaders’ esteem, but possession of even a single quill from a protected bird can send you to prison under federal law (Sept. 11-12)

• New York millionaire defendant Abe Hirschfeld hands out checks of $2,500 each to jurors who decline to convict him on tax fraud charges: was it reasonable doubt, or was it the miles? (Sept. 13)

• Michigan appeals panel finds flamboyant attorney Geoffrey Fieger engaged in “truly egregious” misconduct when he “insinuated, outrageously, and with no supporting evidence” that a doctor “‘abandoned'” his patient “to engage in a sexual tryst with a nurse.” (Sept. 14)

• Michael and me: radical filmmaker Michael Moore vigorously presses charges against ex-employee who, taking a leaf from the methods by which Moore himself won fame, follows him around with a video camera and disrupts his public appearances (Sept. 16)

• Slow down, it’s just a fire: Canadian court is latest to strike down physical fitness tests for firefighters as overly demanding and thus unfair to women (Sept. 17-19)

• Sting operation charges blind Seattle news dealer with selling cigarettes to underage buyer (Sept. 16)

• Charting the vast rise in issuance of law degrees since the 1960s (Sept. 20)

Plus: Don’t you dare hug that hurt or crying child . . . Don’t expect money (even in Philadelphia!) if you get drunk and climb a high-voltage tower . . . and more.

It’s all at overlawyered.com.

Chuck McDannald: “What are the implications of shorting a stock (currently $6/share) that is likely headed for bankruptcy? If it goes all the way to zero, I guess I get the whole $6, is that right? Or what if the company files for bankruptcy protection at some point on the way down? If I ‘know’ they are bankruptcy bound, everyone else does too, so would there even be any shares to short?”

Well, the first thing to say is: shorting stocks is dangerous! “Likely to go bankrupt” isn’t the same as going bankrupt — and if something unexpected happens, this stock (whatever it is) could really jump. Why? Because everyone knows it’s a dog and the price, presumably, reflects that. The only people buying it may be very, very stupid people. But usually — not always — there are as many very, very stupid people selling, so they cancel each other out.

Indeed, some very, very smart people may actually be buying this dog at $6 along with the very, very stupid people. Very, very smart people may on occasion see, or know, something that the rest of us — who are neither brilliant nor Brillo but to whom it’s obvious this stock is headed to zero — may not.

So, point one: who knows.

The next thing to say is that bankruptcy is often not the end of the game. If memory serves (sometimes it does, sometimes it doesn’t), a rotten little clothing retailer called the Gap went bankrupt a long time ago. But it emerged from bankruptcy — the stock never went to zero but got real close in 1988 — and today has a $30 billion market value.

Or look at that rotten Apple that seemed pretty well headed for oblivion. Or at Chrysler that was once a total goner.

So whatever dog you have in mind will PROBABLY go down, which is why people are selling it; but it just might surprise you, which MAY be why some people are buying it.

Now that we have that part settled, here’s the other part. If you short it, you don’t WANT it to go to zero. If it does, you have to realize the short-term capital gain. (Gains on short sales are “short-term” even if you held the short for 100 years, because you sold the stock less than a year and a day after you bought it. In fact, you sold the stock, in this example, 100 years BEFORE you bought it.) So you might well see 30% or 40% of your profit taxed away. Heads you win 60% of your profit after tax, tails you lose close to 100% of your loss. Tough game.

No, what you’d prefer to see is the stock languish for around $1 for years, as it bungles in and out of bankruptcy. That way, no tax is due.

If you want to take a flier betting against this stock, you might be able to buy puts, so at least your risk would be limited to 100% of the cost of the put. But the problem with that is that the seller of the put is no idiot either, ordinarily, so it will cost you a pretty penny . . . and the stock might well hang on around 5 or 6 until long after your put expired worthless.

You can make a lot of many betting on the short side, but very few people do, and the risks are enormous.

Kim Ness: “I promise not to make a habit of writing you, but when you bring up grammar, I find I cannot (a real word, although not used much any more) keep quiet. What about less taxes? Every time I hear a politician promise less taxes, I cringe. I think it ought to be fewer taxes… and that’s right if you count one tax, two tax, three tax etc. But what (most) politicians are trying to say is lower dollars paid in taxes, so that makes me think that maybe I’ve been wrong, and that less taxes is correct. Any thoughts?

Less tax, lower taxes, fewer separate kinds of taxes (New York alone has, like, a million of them). No?

Steve Williams: “You say: ‘Fewer is for things you can count — fewer calories, fewer airplanes, fewer hairs, fewer fat cats, fewer pundits, fewer pedants. Less sand, fewer rocks! Less money, fewer mutual fund choices!’

“You can’t count money?”

Fewer wise-asses.

But seriously, you rarely hear people say “one money, two monies, three monies,” whereas forest rangers are forever saying things like, “one tree, two trees, three trees.” So: fewer dollars, less currency; fewer scents, less perfume.

Michael Rothstein: “Isn’t $90 $10 *less* than $100? Wouldn’t “$10 fewer” sound kind of dumb?”

It would indeed. Ten dollars is less money than $100. And $90 is fewer dollars than $100.

Anonymous: “As a retired English teacher, I am called to expand upon your usage lesson. ‘Less’ can also be used with things that can be counted if those things are considered one unit. An example: ‘Fifty thousand dollars is less than one million dollars.’ Question: what should the grocery-store signs read — ‘Ten items or less’ or ‘Ten items or fewer’?”

“Ten or fewer,” but no grocery store wants to seem highfalutin. Less of a common touch, fewer patrons.

Monday: Shorting a Dying Stock

Greg Buliavac: “OK, I haven’t looked at your mutual fund cost calculator, but my question is, why do you need to consider the costs of a fund? Why don’t you look just at the performance numbers, since performance is calculated after costs are subtracted?”

This is exactly the right question and a lot of you have asked it. We try to answer it in what I guess is too hidden a place on the Mutual Funds Cost Calculator site. (You reach it by clicking “more” on the first page.) Click here for a direct link. Two sections are most relevant: Because Predicting Costs Is Much Easier than Predicting Performance . . . and . . . But Don’t You “Get What You Pay For?”

But if you have time, read it all and let me know what you think.

Rodney Skidmore doesn’t buy it. He writes: “Give me an ‘expensive’ manager that delivers over a low cost manager that loses money, any day.”

Absolutely! Of the 11,000 funds out there, please list for me, below, any 3 that will significantly beat the market over the next few years on an after-tax basis:

1. _________________

2. _________________

3. _________________

We’ll check back a few years from now, and you’ll probably be rich and I’ll probably look like an idiot.

Even so, it’s just a lot harder finding these funds looking forward than back. Which is why instead of comparing a high cost manager that “delivers” with a low cost manager that loses money, I’d compare the high cost manager with a low cost manager that makes money — as so many do.

It’s counter-intuitive that really bright guys and gals who work at it can’t fairly consistently beat the market, and by more than the extra 3%-a-year handicap, say, that a high-cost, tax-inefficient mutual fund might have to bear. After all, in a normal environment, where stocks may be expected to return about 10% a year, having to do 3% better than the pack to cover the added costs — just to wind up doing average, that is, after costs and taxes are deducted from an investor’s return — is merely to have to do 30% better than the rest. And why should that be hard?

Well: it is.

And, with a high-cost, tax inefficient fund, that merely gets you even with the pack. Actually to beat the pack, you have to do better still.

I was riding up Sixth Avenue and saw that billboard with the National Debt in bright lights spiraling $10,000 deeper into hock with every passing second. It’s an astonishing thing, really, to see the numbers whirring fast enough to add $10,000 a second. The right-most digit . . . the one-dollar bills . . . must be racing around at 10,000 increments a second, if they actually do it right. (Maybe they round to the nearest $1,000, so it grows $1,000 every tenth of a second. Still makes for a heck of billboard.)

I’m not sure how many trillions of dollars ago it was erected; but this thing has been lighting up the avenue and making people feel bad for a long, long time now, 24 hours a day, 7 days a week, for years.

And the point is: It stopped.

It’s conceivable the sign was just broken the day I passed, but I don’t think so. The lights were as bright as ever, so the power was on.

No, it had stopped. <Partisan hat ON> The Clinton/Gore budget of 1993 . . . the budget that received not a single Republican vote but that was designed to appease the bond market and get interest rates falling so employment could start rising so the deficit could start falling instead of rising . . . that budget worked. And the Democrats want to maintain the same fiscal responsibility to keep the economy growing responsibly. No gargantuan tax cuts right now, thank you; that’s what you do when you need to give the economy a boost, not what you do when the economy is booming and unemployment is low. <Partisan hat OFF>

The point is: The National Debt Clock had stopped.

And somebody, someplace, is scratching his head wondering if it’s worth trying to run the thing backwards, or better to just replace it with something else.

With minor readjustment it could be a world population clock — 6 billion any minute now, up from 2.5 billion when I was born, and growing by a new Mexico every year. (Not a New Mexico, mind you — a new Mexico.)

Or if it can be rigged to run backwards, it could be a Remaining Acres of Rain Forest clock. Or a Remaining Population of Atlantic Salmon clock.

Or maybe it should just be turned into a billboard for Honest Tea.

Tomorrow: Why Consider Mutual Fund Cost at All When It’s Already Figured into Performance?!

What’s ordinarily thought of as double taxation of dividends is this: You own a company. It makes a profit. That profit is taxed once to the corporation, and then a second time when you receive it as a dividend. (Corporations have been prety aggressive in getting around this by finding ways to pay little or no corporate income tax, and by paying out little or no dividends. Many buy back their own stock instead, which in theory will give the value of your stock — and, especially, the value of management’s options — a little lift.)

But there’s another double taxation of dividends that’s inadvertent and entirely avoidable. I referred to it last week.

Lynn Smith: “You say: ‘I’m also assuming you are not accidentally double-counting as taxable gains appreciation from reinvested dividends. You’ve already paid tax on that portion of the growth in the value of your holdings. This is a common mistake.’

“I don’t consider myself a novice, but I’m not following your comment about double-counting. I’m taxed on it when I receive a dividend. The fact that I choose to reinvest that dividend income or just invest the same amount of regular old money has no bearing on whether its appreciation will be taxed. Both would be taxed equally when sold. What am I missing?”

Say you put $10,000 into a fund and check “reinvest dividends.” Now 5 years later, it’s $20,000. This is just great, and congratulations.

You sell.

Some people make the mistake of entering $10,000 as their cost, $20,000 as their proceeds, and pay tax on the $10,000 profit.

You, of course, have added to that original $10,000 cost the additional cost of all those additional shares you purchased by reinvesting your dividends — and on which you paid income tax each year.

Let’s say you got and reinvested $3,000 in dividends and capital gains over the five years. Where some might accidentally show $10,000 as their cost, $20,000 as their proceeds, and pay tax on the $10,000 profit, you show a cost of $13,000 and pay tax on only the actual $7,000 previously-untaxed profit. The folks who declare a $10,000 gain are paying tax on the previously taxed $3,000 TWICE.

Robert Doucette: “How do I figure out how much I would owe in Capital Gains from a mutual fund investment? I know how much was paid originally and how it is worth now, but every year we pay taxes on the funds in our taxable accounts? Surely we are paying the Capital gains on the installment plan?!?”

Same deal. If you’ve been reinvesting the dividend/gains distributions, you have to keep track of them (or get the fund to send you a recap). Add all your reinvested dividends to your cost for the original shares, so you get a total of all you’ve paid for the original, plus the additional, shares.

On the other hand, if you’ve been getting actual checks — and using them to pay the rent rather than reinvesting them — any gain in your account is taxable. It’s a gain on your original shares, which is all you have. If you paid $10,000 and sell for $17,000, that’s a $7,000 gain, plain and simple.

Yes, if the fund distributed lots of dividends and capital gains each year, you did pay a lot of tax along the way. But whenever it paid cash out, it also lowered its net asset value per share.

Shares you bought at $10 that rose $4 in net asset value to $14 and then paid out a $4 capital gains distribution are instantly, after the pay-out, back to $10. If you sell, there is no gain.

Indeed, while it’s not always a great idea to buy shares in a fund just before a large capital gains distribution is paid, it’s not quite the disaster people warn of, either. Say you paid $14 Tuesday and the next day, Wednesday, you got a $4 taxable distribution. Well, if this is going to cause you a problem, just sell the shares — now instantly $10 a share after distributing the $4 — and you will have a $4-a-share loss to net out the $4-a-share gain. (Of course, if this were a load fund, or a fund with a surrender charge, you couldn’t be so cavalier about it.)

Have I just left you more confused? Well then, enough mutual funds for a day or two.

Tomorrow: A Broken Clock That’s Right All Day