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Taxes, expenses reduce stock returns

The Baltimore Sun

There's no telling how stocks will end up in 2007, especially after the rocky start. One thing is certain, though: Investors can't count on always receiving the double-digit returns of last year.

In an unpredictable market, how can you maximize returns?

Focus on the things you can control: taxes and expenses.

Last year, the Standard & Poor 500's index, which tracks widely held stocks of major U.S. companies, had a total return of 15.8 percent, including dividends.

This year the market is proving more sluggish. While the S&P; 500 had returned 4.9 percent in the first quarter of 2006, according to Thomson Financial, this year it has eked out 0.8 percent.

That's better than the negative returns posted in February, as U.S. stocks reacted to news of troubled mortgage lenders and performance slumps in markets abroad.

Many experts don't expect a significant rebound in 2007 - at least not to the double-digit returns of 2006.

"At best, U.S. equity investors will get what's been typical of the long run historically, which is mid- to high single-digit returns with a lot of volatility thrown in," said Mark Zandi, chief economist for Moody's Economy.com Inc.

The S&P; 500's annual total return has averaged 8.2 percent over the past 10 years, according to Standard & Poor's, despite remarkable gains in the late 1990s.

Single-digit returns for U.S. stocks are far from unusual, making now the perfect time to lower any costs that threaten to eat into your portfolio's gains. Some hints:

Use retirement accounts.

Taxes are one of the biggest drains on stock returns.

Although recent changes in federal law have reduced the tax rate on dividends and capital gains (the money your investments earn) to historically low levels, the best tax bill is one that amounts to zero.

For retirement savings, there are two main investment vehicles that allow your cash to grow tax-deferred: an employer-sponsored retirement plan, such as a 401(k) or 403(b), and an individual retirement account.

With both types of accounts, you don't pay taxes on the returns you earn for as long as the money is invested. You pay income taxes only when you begin withdrawals. And with Roth versions of the accounts, you don't pay taxes on withdrawal, but you don't get to deduct your contributions upfront.

Surveys often point out that fewer young workers contribute to a company 401(k) than older workers. Typically the reason is a lack of cash flow: Young workers just don't feel their paychecks allow for retirement saving.

But if you're skipping the 401(k) to open a taxable brokerage account, consider this: A $10,000 investment that earns 8 percent annually for 30 years would grow to about $100,600.

Pay even the lowest tax rate on capital gains (now 5 percent), and your average annual return would be reduced to 7.4 percent, giving you slightly more than $85,100.

Go for low fees.

Fees you pay to invest are the other big drain on growth.

This concept, of course, is not new. John Bogle, who popularized index funds, has long trumpeted the importance of minimizing mutual fund fees, often written as an expense ratio.

But a study last spring from the Yale School of Management shows that investors routinely ignore costs. When groups of MBA and college students were given fee information about index funds, 85 percent failed to pick the fund with the lowest fee.

Index funds, remember, are not actively managed. Rather, they track broad markets.

The average expense ratio for U.S. stock funds that are actively managed is 1.46 percent, according to Morningstar Inc.

Index funds, on the other hand, average 0.71 percent.

Pay anything more, and you're just making the market's slowdown that much worse for you.


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