Five Strategies for Tax-Efficient Investing
Key Points
- Invest in Tax-Deferred and Tax-Free Accounts
- Consider Government and Municipal Bonds
- Look for Tax-Efficient Investments
- Put Losses to Work
- Keep Good Records
- Points to Remember
As just about every investor knows, it's not what your investments earn, but
what they earn after taxes
that counts. After factoring in federal income and capital gains taxes, the
alternative minimum tax, and any applicable state and local taxes, your
investments' returns in any given year may be reduced by 40% or more.
For example, if you earned an average 8% rate of return annually on an
investment taxed at 28%, your after-tax rate of return would be 5.76%. A
$50,000 investment earning 8% annually would be worth $107,946 after 10 years;
at 5.76%, it would be worth only $87,536. Reducing your tax liability is key to
building the value of your assets, especially if you are in one of the higher
income-tax brackets. Here are five ways to potentially help lower your tax
bill.1
Invest in Tax-Deferred and Tax-Free Accounts
Tax-deferred accounts include company-sponsored retirement savings accounts
such as traditional 401(k) and 403(b) plans, traditional individual retirement
accounts (IRAs), and annuities. Contributions to these accounts may be made on
a pretax basis (i.e., the contributions may be tax-deductible) or on an
after-tax basis (i.e., the contributions are not tax-deductible). More
important, investment earnings compound tax deferred until withdrawal,
typically in retirement, when you may be in a lower tax bracket. Contributions
to nonqualified annuities, Roth IRAs and Roth-style employer-sponsored savings
plans are not tax-deductible. Earnings that accumulate in Roth accounts can be
withdrawn tax free if you have held the account for at least five years and
meet the requirements for a qualified distribution.
Pitfalls to avoid:
Withdrawals prior to age 59½ from a qualified retirement plan, IRA, Roth IRA,
or annuity may be subject not only to ordinary income tax, but also to an
additional 10% federal tax. In addition, early withdrawals from annuities may
be subject to additional penalties charged by the issuing insurance company.
Also, if you have significant investments, in addition to money you contribute
to your retirement plans, consider your overall portfolio when deciding which
investments to select for your tax-deferred accounts. If your effective tax
rate -- that is, the average percentage of income taxes you pay for the year --
is higher than 15%, you'll want to evaluate whether investments that earn most
of their returns in the form of long-term capital gains might be better held outside of a
tax-deferred account. That's because withdrawals from tax-deferred accounts
generally will be taxed at your ordinary income tax rate, which may be higher
than your capital gains tax rate (see "Income vs. Capital Gains").
Consider Government and Municipal Bonds
Interest on U.S. government issues is subject to federal taxes but is exempt
from state taxes. Municipal bond income is generally exempt from federal taxes,
and municipal bonds issued in-state may be free of state and local taxes as
well. An investor in the 33% federal income-tax bracket would have to earn
7.46% on a taxable bond to equal the tax-exempt return of 5% offered by a
municipal bond, before state taxes. Sold prior to maturity or bought through a
bond fund, government and municipal bonds are subject to market fluctuations
and may be worth less than the original cost upon redemption.
Pitfalls to avoid:
If you live in a state with high state income tax rates, be sure to compare the
true taxable-equivalent yield of government issues, corporate bonds, and
in-state municipal issues. Many calculations of taxable-equivalent yield do not
take into account the state-tax exemption on government issues. Because
interest income (but not capital gains) on municipal bonds is already exempt
from federal taxes, there's generally no need to keep them in tax-deferred
accounts. Finally, income derived from certain types of municipal bond issues,
known as private activity bonds, may be a tax-preference item subject to the
federal alternative minimum tax.
Look for Tax-Efficient Investments
Tax-managed or tax-efficient investment accounts and mutual funds are
managed in ways that can help reduce their taxable distributions. Investment
managers can employ a combination of tactics, such as minimizing portfolio
turnover, investing in stocks that do not pay dividends, and selectively
selling stocks that have become less attractive at a loss to counterbalance
taxable gains elsewhere in the portfolio. In years when returns on the broader
market are flat or negative, investors tend to become more aware of capital
gains generated by portfolio turnover, since the resulting tax liability can
offset any gain or exacerbate a negative return on the investment.
Pitfalls to avoid:
Taxes are an important consideration in selecting investments but should not be
the primary concern. A portfolio manager must balance the tax consequences of
selling a position that will generate a capital gain versus the relative market
opportunity lost by holding a less-than-attractive investment. Some mutual
funds that have low turnover also inherently carry an above-average level of
undistributed capital gains. When you buy these shares, you effectively buy
this undistributed tax liability.
Put Losses to Work
At times, you may be able to use losses in your investment portfolio to help
offset realized gains. It's a good idea to evaluate your holdings periodically
to assess whether an investment still offers the long-term potential you
anticipated when you purchased it. Your realized losses in a given tax year
must first be used to offset realized capital gains. If you have
"leftover" losses, you can offset up to $3,000 against ordinary
income. Any remainder can be carried forward to offset gains or income in
future years, subject to certain limitations.
Pitfalls to avoid:
A few down periods don't mean you should sell simply to realize a loss. Stocks
in particular are long-term investments subject to ups and downs. However, if
your outlook on an investment has changed, you can use a loss to your
advantage.
Keep Good Records
Keep records of purchases, sales, distributions, and dividend reinvestments so
that you can properly calculate the basis of shares you own and choose the
shares you sell in order to minimize your taxable gain or maximize your
deductible loss.
Pitfalls to avoid:
If you overlook mutual fund dividends and capital gains distributions that you
have reinvested, you may accidentally pay the tax twice -- once on the
distribution and again on any capital gains (or underreported loss) -- when you
eventually sell the shares.
Keeping an eye on how taxes can affect your investments is one of the easiest
ways you can enhance your returns over time. For more information about the tax
aspects of investing, consult a qualified tax advisor.
Points to Remember
- Taxes on income and capital gains
distributions reduce your after-tax rate of return. - Maximize opportunities to invest in
tax-deferred and tax-free retirement accounts. - Consider your overall investment portfolio
when selecting investments for tax-deferred and tax-free accounts. You might
first allocate investments that generate interest income to tax-qualified
accounts, since withdrawals from these accounts are taxed as ordinary income. - Income from municipal bonds is generally
exempt from federal and in some cases state and local taxes. Capital gains are
taxable, and returns from some types of municipal bonds may be subject to the
alternative minimum tax. - Tax-managed mutual funds and investment
accounts employ strategies aimed at reducing taxable distributions. - Realized capital losses can be offset against
capital gains, and up to $3,000 in losses can be offset against ordinary income
in a given tax year. - Maintaining good records of investment
purchases, sales, and distributions is essential to evaluating the best method
of determining gains and losses for tax purposes and calculating the adjusted
cost basis of an investment.
1This information is general in nature and is not meant as tax
advice. Always consult a qualified tax advisor for information as to how taxes
may affect your particular situation.
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© 2011 McGraw-Hill
Financial Communications. All rights reserved.
July 2011 — This column is provided through the Financial
Planning Association, the membership organization for the financial planning
community, and is brought to you by Ronald J VanSurksum, CFP® , a local member
of FPA.
