Build your own tax-deferred investments

Nation's Business, July, 1998 by Randy Myers

Ask any investment professional where you should save for retirement, and you're likely to get one of two answers--an individual retirement account or a 401(k) savings plan.

In most cases, they're right. Both 401(k)s and IRAs are attractive investment vehicles because they postpone tax bills on your investment income. At the end of each year, money you otherwise would send to the Internal Revenue Service stays in your account, where it can continue to compound. Of the two types of plans, a 401(k) is especially attractive if your employer matches part or all of your contributions.

Unfortunately, not everybody has access to a 401(k) plan. IRA contributions are limited to $2,000 a year, and tax-deductible IRAs are restricted by income caps.

If these limitations apply to you, don't despair. You can build a tax-deferred stock portfolio that mimics a 401(k) plan and hold it until retirement. Until you start to sell, your capital gains--and your taxes on those gains--will be deferred.

To be sure, not every stock in a buy-and-hold portfolio will prove to be a winner. "When it's time to start cashing out, your portfolio is bound to include losers as well as winners," explains James Rich, senior investment strategist for IBM Retirement Funds, IBM Corp.'s pension-management arm in Stamford, Conn.

"As you start to withdraw money from your account, sell the losers first. Since they've lost money, you'll owe no tax on those proceeds. In the meantime, your winners can stay in your portfolio and continue to compound tax-free."

You can establish your own tax-savvy stock retirement fund with a very modest amount of money. Many brokerage firms will allow you to open an account with as little as $2,000. Thereafter, you can make stock purchases on whatever schedule best fits your budget.

If you must sell early at a profit, you can either pay taxes on your gain at that time or offset the gain by selling another stock that has gone down in value. To the extent that the loss on the second stock equals the gain on the first, you'll owe no capital gains tax.

Here are several pointers for building your own tax-deferred retirement account:

Diversify your holdings. The fewer stocks you own, the greater the chance that one really bad one will ruin your entire portfolio. If you're starting your fund on a budget, go ahead and buy one or two stocks, and just add more over time. Your goal should be to own at least 10 stocks--preferably in half a dozen or more industries--to ensure adequate diversification. But don't overdo it. A portfolio of more than 20 stocks could be difficult to track and manage.

Choose stocks with good potential for long-term growth. Easier said than done, of course. Still, you can avoid obvious risks, like sinking a ton of money into that little company that just made millions producing a best-selling video game. Yes, it's hot today, but it could be out of business tomorrow. Pepper your portfolio with a few of these long shots if you must, but you'll sleep easier if you emphasize established companies in growing industries.

Maximize tax efficiency by avoiding stocks that pay hefty dividends. While capital-gains taxes aren't due until you sell a winning stock, dividends are taxable for the year in which they're received. Yes, dividends are nice for income-oriented investors--especially when stock prices are falling. But you're not looking for current income from this account. Either avoid dividend-paying stocks such as utilities, banks, and vertically integrated oil companies, or hold their shares in an IRA.

Consider using a discount stockbroker. If you do your own stock research, there's little reason to use a full-service broker, for whom the commission for a single trade can exceed $100. Commissions at discount brokers are as low as $8 if you trade over the Internet, $35 by phone.

Open a Roth ERA. If you are under the income caps that determine eligibility for a Roth IRA, put your first $2,000 of retirement savings into one of those each year. (The maximum contribution is permitted to individuals with adjusted gross income up to $95,000, with reduced contributions above that cap phased out at $110,000. For married couples filing jointly, the income limits are $150,000 and $160,000.) While earnings from your do-it-yourself retirement plan are tax-deferred until withdrawal, earnings in a Roth IRA are tax-free forever after the account has been open for a minimum of five years.

Over time, you'll find that managing your own tax-deferred retirement account takes patience--especially when the stock market gets choppy and other investors panic. Just remember that in 61 of 63 overlapping 10-year periods since 1929, U.S. stocks have earned positive returns, according to Ibbotson Associates, a Chicago research firm. And there have been no 15-year or 20-year periods since that time in which stocks have lost money. If history even comes close to repeating itself, your do-it-yourself retirement fund will prove rewarding indeed.

Randy Myers, formerly a writer and editor for Dow Jones & Co., Inc., is a financial writer in Dover, Pa.