Whether or not the 15% tax rate on dividends and long-term capital gains survives, there are things you can do to reduce the government's cut of your gains in taxable accounts. Obviously, you want to try to hold on to stocks and funds for at least a year and a day to qualify for the 15% long-term rate. Otherwise, your gains are considered short-term and are taxed at ordinary-income rates of up to 35%.
If you don't need income, consider tilting your holdings toward stocks that don't pay dividends. The tax you must pay annually on dividends reduces the amount you can reinvest, and over time the cost of that lost opportunity can add up (see the table at left). With non-dividend-paying growth stocks, you postpone your tax bill until you sell your shares, preferably at a gain.
Now is a good time to focus on growth stocks; after six years of lagging the market, they revived in 2007. The Russell 3000 Growth index outpaced the Russell 3000 Value index by 12 percentage points last year. "We're still in the early phases of a transition to growth," says Rick Jandrain, co-manager of the Touchstone Diversified Small Cap Growth fund. "Everybody is worried about the economy, so people are looking for predictable earnings growth."
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Take EMC, which dominates a maturing but still-growing market for corporate data storage and has a big stake in a young and burgeoning technology known as virtualization. EMC (symbol EMC) owns 86% of VMware (VMW), the leading supplier of virtualization software, which allows a single computer server to run multiple applications simultaneously. Analysts see EMC's earnings growing 20% this year and 13% annually over the next five years.
This double-digit earnings growth appears to be on sale for a bargain price. Some analysts argue that EMC's share price, $16 in mid January, doesn't reflect the company's stake in VMware, which has seen its shares explode from $29 when the firm went public last August to $78 recently. Bear Stearns analyst Andrew Neff values EMC's VMware stake at $17 to $19 a share, in which case you would get all of EMC's data-storage business and its $5.8 billion in cash essentially for free.
Another promising growth stock that doesn't pay dividends is comScore, a leading authority on consumers' online activities. The company (SCOR) collects and analyzes massive amounts of information on which sites consumers visit and why, then packages the data in a variety of products sold to online advertisers and e-commerce firms. "It's a great business, especially at a time when advertising dollars are just pouring over the transom from traditional media to the Internet world," says Bill McVail, manager of Turner Small Cap Growth fund.
The data analyzer is growing rapidly, so don't be scared off by its price-earnings ratio of 41. If comScore can meet analysts' forecasts of better-than-30% annual earnings growth over the next five years, its shares, recently $30, should prosper.
A company that appears to be on the leading edge of a long growth curve is Hologic. It makes a variety of products that screen for and diagnose breast and cervical cancer, osteoporosis and other conditions common to women. The company (HOLX) is benefiting from the ongoing conversion from analog to digital x-rays for breast-cancer screening, and it appears to have a lead over its rivals in the development of a device for three-dimensional breast imaging. Company officials confidently project long-term revenue and earnings growth of 20% or better. The stock recently traded at $70.
Pay Uncle Sam on your terms
You're better off in a taxable account with the stock of a fast-growing company that pays no dividends rather than with a plodder that pays out much of its profits. In the examples below, both stocks return 10% a year. But the growth stock achieves its return entirely through appreciation, while the other one gains 6% a year and pays a 4% dividend yield. Calculations assume dividends are reinvested in shares and are taxed at a rate of 15%. With the non-dividend payer, you'll pay capital-gains taxes only when you sell.
| The value of a $10,000 investment after taxes | ||
| Row 1 - Cell 0 | 5 years | 10 years |
| Non-dividend-payng stock returning 10% a year | $16,105 | $25,937 |
| Dividend-paying stock returning 10% a year | 15,671 | 24,557 |
| How much more you've kept with non-dividend payer | $434 | $1,380 |
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