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Investment Planning |
Your Fun Money Portfolio
The stock market has given us some exciting ups and some thrill-dampening downs recently. Your retirement savings should be invested in a diversified portfolio, including large cap, small cap, and international investments. However, if you consider breaking away from your asset allocation to do what some may call gambling, make sure that you do this with only a small portion of your investment portfolio. A good rule of thumb for investing the speculative portion of your portfolio is to invest no more than three to five percent of your total portfolio. Call this your "fun money" portfolio.
It's a good idea to consider this money gone for good. Deviating from your diversified portfolio to branch out into speculative investments means that you should monitor your performance for both psychological and tax reporting reasons. You'll then be able to see both your successes and failures. Since it's common for investors to remember their successes more vividly than their losses, this strategy will help keep you grounded in reality. If you hold your fun money in a taxable account, you'll be required to report sales transactions on your tax return.
Consider your specific trading habits to determine whether to hold speculative investments in your taxable account or in a tax-deferred account such as an IRA. If you hold the riskier investments in a taxable account and if their value does tank, you can deduct up to $3,000 of losses per year against your ordinary income such as wages and dividends. On the other hand, if you are doing lots of trades with your speculative portfolio, you may decide to trade in your retirement account to ease your paperwork burden. This way, you won't have to list all of your sales transactions on your tax return, since gains and losses incurred in a tax-deferred account are never taxed.
Consider opening a separate account for your fun money portfolio. You may also choose to open an account at a fund company other than the one that holds your retirement savings, so that you can truly segregate these funds.
Each time you trade individual stocks, you'll usually pay fees. Use a discount broker or low-cost on-line broker for your trades to keep fees down. Make sure you account for the fees you pay for tax purposes. In a taxable account, trading fees can either reduce your gain or increase your loss. For example, if you pay $29 per trade, the $29 to buy a stock increases your cost basis, and the $29 to sell a stock will reduce your sales proceeds. If you're trading in a tax-deferred account (for example, an IRA) and have high miscellaneous itemized deductions (such as tax preparation fees, legal fees for the production of income or investment management fees) that are in excess of two percent of your adjusted gross income, include your trading fees as an itemized deduction on your tax return to get a tax deduction.
Research by academics has shown that the best performing mutual funds and stocks continue to perform well in the next year; however loser funds and stocks tend to keep on losing. So, remember to follow the old saying for your speculative investments: cut your losses and let your winners ride.
Have fun with the portfolio, but don't let it exceed five percent of your total investments. And keep in mind the three rules of the savvy investor: save diligently, keep your investment portfolio diversified, and keep your investment costs low.
Tips Disclaimer
These tips contain information that may change over time as a result of new tax legislation. Although we make efforts to keep this information current, you should check with your tax advisor before taking action based upon any information contained in these tips.