by Archie M. Richards, Jr., CFP^®
November 26, 2001

If you're pessimistic about the stock market, here's what you should do:

Nothing. As long as your investments are well diversified, just keep holding.

But, hey, do I look like I know everything? Maybe your pessimistic prediction is correct. Here are two funds that engage in a technique, called short selling, which enables investors to profit when prices fall:

• The Rydex Arktos Fund: When the 100 largest Nasdaq stocks fall by 10 percent, the price of the Arktos Fund rises by 10 percent.

• The Rydex Tempest 500 Fund: This one has 2-to-1 leverage. When the S&P 500 goes down by 10 percent, the Tempest 500 rises by 20 percent.

But if you're wrong about the market falling, the results can be devastating. Let's say that Jean invests $10,000 in a fund that tracks the S&P 500 Index. The S&P 500 rises by 30 percent, leaving her with $13,000.

Jean's husband Charlie fancies himself an investment swinger. He places $10,000 in the Rydex Tempest 500. The S&P 500 rises by 30 percent. The price of Charlie's fund falls by 60 percent. He's left with only $4,000.

Charlie's $4,000 would have to gain by 325 percent to equal his wife's $13,000. But while he's attempting this, Jean's account presses on to new highs. Charlie can never catch up - not for the rest of his life.

Periods of unfavorable news, when prices are low, are the times not to sell. Even if you feel pessimistic, keep holding, through thick and thin. The government recently created tax advantages for investors who hold for at least five years. If your top income-tax bracket is 28 percent or higher, your five-year capital gains tax is capped at 18 percent (down from 20% previously). If your top bracket is 15 percent, the five-year capital gains tax is capped at 8 percent (down from 10%).

Take advantage. Hold for five years and preferably longer.

Beginning in 2002, if you're a youngster under 50 years old, you can contribute $3,000 a year (up from the current $2,000) to Traditional or Roth IRAs. If you're 50 or over, you can contribute an extra $500, making $3,500 a year.

The amount you can deduct for a Traditional IRA and whether you can contribute at all to a Roth IRA depend in both cases on the amount of your modified adjusted gross income.

Huh? More about that tax term shortly. First, the impact on IRAs.

If you file a joint return, the amount you can deduct for a Traditional IRA drops as your modified adjusted gross income rises above $54,000. When the modified adjusted gross income (AGI) reaches $64,000, you lose the deduction altogether.

The range of the modified AGI in which you gradually lose eligibility for contributing to a Roth IRA is $150,000 to $160,000.

Okay, what is modified adjust gross income?

It's difficult enough to determine your unmodified adjusted gross income. That's the number at the bottom of page 1 of the IRS Form 1040. But the modified AGI is complicated to absurdity. It's your adjusted gross income with the following tax advantages removed:

• Traditional IRA deduction

• Student loan interest deduction

• Foreign earned income exclusion

• Foreign housing deduction

• Qualified interest on U.S. Savings Bonds used for higher education

• Exclusion of employer-paid adoption expenses

By removing these tax advantages, your modified adjusted gross income becomes larger. This makes it less likely that you can contribute to an IRA. The Congress creates tax benefits in one place (the six advantages above), but pulls them back in another (less chance of using IRAs).

The Tax Foundation expects the cost of complying with federal income taxes to reach $140 billion this year. That's just the cost of compliance, not the taxes paid. By making taxes complicated, the members of Congress help no one but themselves. The complexity enables them to talk out of both sides of their mouths. They can say to one group, "See, we're helping you over here." To a group with an opposing interest, they can say, "See, we're helping you over there." The trouble is, the costs are borne by everyone.

Have I told you that I hate taxes?