How To Be a Tax-Savvy Investor

A tax-savvy investor knows how to employ strategies to reduce taxes. Helpful methods are 1) asset location, 2) tax-managed mutual funds, 3) index exchange-traded funds and 4) tax loss harvesting.

Finally, higher income earners (individuals and jointly filing couples who exceed $200,000 and $250,000 of modified adjusted gross income, respectively) may consider some investments – such as municipal bonds and qualified dividend-paying stocks ­– to reduce net investment income in light of the 3.8 percent surtax on investment income for wealthier folks that began last year.

Asset location. Think of your investment portfolio as a garden. Certain plants do well in full sunlight, but others benefit from shade. Plants designed to flourish in the shade can wilt and die in full sunlight. Similarly, some investments do exceptionally well in tax-deferred accounts but others are better suited to taxable accounts. Ideal investments for tax-deferred accounts include real estate investment trusts (REITs), commodities (buying futures contracts can bring you taxable gains), most bonds and bond funds and high dividend-paying stocks.

Conversely, self-described tax-efficient stock mutual funds, growth-oriented stocks and untaxed municipal bonds all fare better in taxable accounts. Your time horizon also counts – if you’re in your 50s, concentrate more bond holdings in tax-deferred accounts. However, if you’re several decades from retirement, hold relatively more stocks in your tax-deferred accounts since they should outpace bond growth for an extended period before you tap them.

Roth individual retirement accounts are ideal for holding stocks that you can allow to run for decades. You invest in a Roth IRA with after-tax dollars, and it grows tax-fee from there on out. Plus, this account has no required minimum distribution, like a regular IRA or 401(k), where you must start withdrawing from it at age 70½.

Not everyone has the ability to allocation perfectly between taxable and tax-deferred accounts. If most of your money is concentrated in taxable or tax-deferred, asset diversification may trump tax efficiency. Here are some red flags when I review clients who come to me from elsewhere: little or no difference between taxable and tax-deferred investment holdings, REITs and commodities in taxable accounts, untaxed muni bonds in tax-deferred accounts.

Ways to reduce investment taxes in taxable accounts. You’d be surprised how quickly additional tax savings deliver better investment returns. Strategies here include investing in “tax-managed” (or “tax advantaged”) mutual funds – if you can find them. These funds avoid heavy buying and selling of underlying assets because that action often racks up lots of capital gains from sales. Because mutual funds are required to distribute capital gains to shareholders, the tax bill for those get passed on to you.

The corollary is that you should avoid high-turnover mutual funds. Finally, although few investors do it, mining a fund prospectus can help identify funds with large unrealized appreciation, so you can give them a wide berth. At some point, the fund might sell these high-valued assets, and you get a big tax bill.

If you’re a do-it-yourself investor, Vanguard, for example, has several tax-managed mutual funds that reduce your tax bite. I use tax-advantaged Dimensional Fund Advisors mutual funds with my clients in their taxable accounts. Investing in index ETFs in taxable accounts lowers taxes on investments. These ETFs, as the name implies, track index funds like the Standard & Poor’s 500, and thus only occasionally need to add and shed stocks to rebalance. An index mutual fund must do this by actually buying and selling stocks; an ETF is structured differently, so it can do in-kind swaps, which don’t trigger capital gains. Plus, ETFs don’t have to sell stock positions to meet redemptions, as conventional mutual funds do.

Beware of holding mutual funds that have fallen out of favor and are selling positions to meet redemptions. The result can be significant capital gains tax; the tax bite is even worse if the fund held the position less than one year. Imagine holding a fund that’s fallen in price and makes a capital gains distribution to you – the shareholder.

In this instance, tax harvesting can reduce the sting. I utilize a tax optimization program for my clients but you may find your own tax harvesting opportunities if you’re a do-it-yourself investor. That’s where you sell a stock that is worth less than what you paid for it. The loss offsets any gains.

A May 26 article by William Baldwin (“Are Mutual Funds Boosting Your Taxes?”) in Forbes magazine gives a great example: You purchase a fund for $78 and it distributes an $18 long-term gain a month later. Your $78 share price is reduced to $60 and you owe tax on this $18 long-term gain. His advice? Sell the fund so the $18 share price loss cancels out the $18 distribution. You break even at tax time.

Reducing net investment income subject to the 3.8 percent surtax. The new 3.8 percent surtax introduced in 2013 affects net investment income if your modified adjusted gross income (MAGI) exceeds $200,000 (individuals) or $250,000 (couples filing jointly). Some investments that suppress investment income include municipal bonds and investments in dividend-paying stocks with “qualified” dividends, where you pay a lower rate than for ordinary income.

For instance, with stock, its dividends get the favorable treatment if you have held it for 61 days out of the 120 days that began 90 days before the ex-dividend date, which determines when the buyer gets the payout.

In sum, there are various ways to put more sizzle in your investment return by lowering taxes but the tax tail should not wag the investment dog. A good advisor will structure a diversified investment portfolio that utilizes asset location and tax techniques to give you the best of all possible worlds: less volatility combined with returns that outpace inflation and lower your tax bill.

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Written by Eve Kaplan, CFP, a fee-only advisor in Berkeley Heights, N.J. Kaplan Financial Advisors is a Registered Investment Advisor in New Jersey and New York.

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