4 Tax-Day Tips For Portfolio Construction

Source: Thinkstock

With federal tax season coming to a close, I thought it would be useful to go through some advice that will help investors minimize their obligations to Uncle Sam. While it is too late to do anything about 2013 taxes if you follow these simple tips going forward you can limit the amount of taxes you pay on your investments.

1. Stock buybacks are preferable to dividends

 This is especially apparent if you reinvest your dividends. Keep in mind that if a company pays a dividend to you of $100 that this is taxed at the capital gains rate of either 15% or 20%. Therefore you only get to reinvest $80 or $85 when the dividend is paid. If the company had used that money instead to buy back stock, you are effectively reinvesting all $100.

However, keep in mind that stock buybacks aren’t always preferable to dividends. Management can use stock buybacks to inflate the share price or to mask dilution in the form of stock options being granted to executives. Therefore keep an eye out for quality buybacks. A good strategy is to look for companies that allocate some money towards both buybacks and dividends.

2. Watch out for bonds!

Income from bonds, particularly corporate bonds, is taxed as ordinary income. For most investors, this is a higher rate than the capital gains rate. While investors can save on taxes by buying municipal bonds—which are tax free if you buy them in the state in which you reside—the market adds this advantage into the price. So if you have two bonds with roughly the same maturity and risk of default, and one is a corporate bond and another is a municipal bond, the market is going to assign the former a coupon that is larger than the coupon on the latter so that after taxes they have roughly the same coupon. In other words: there is no advantage.

One trick is to look for companies that manage bond portfolios. Business development corporations are a good way to do this. These companies lend money to young companies that need capital. Hercules Technology Growth Capital (NYSE:HTGC) is one such company. Buying a company like this enables you to get high yield bond-like returns while paying capital gains rates on the income.  Just make sure you understand the risks of owning a company that manages a bond portfolio.  Make sure you aren’t losing out to overpaid executives, and make sure that the investments fit your level of risk tolerance.

3. If you don’t like a lot of paperwork then steer clear of limited partnerships

If you own stock in a limited partnership, then most of the income it generates is distributed to you as income. These are great because the company itself doesn’t pay any taxes on it. This means that limited parnterships aren’t double taxed, and you get to keep more of the profits.

The trouble is that, for every single one of these, you have to fill out a special tax form called a Schedule K-1. These can be confusing and time consuming. Therefore don’t buy shares in a limited partnership unless you have a lot of confidence in that company’s business—enough so that you don’t mind doing the extra paperwork each year. Also, limit yourself to one or two of these. Finally, be very careful, as some ETFs are organized as limited partnerships. For instance the United States Brent Oil Fund (L.P.) (BNO) is a limited partnership that generates no income.

4. Hold positions long term

There are a couple of reasons to do so. First, if you hold an asset for less than a year, then you have to pay ordinary income tax on the gains as opposed to capital gains tax.

Second, even if you hold a stock for longer than one year, you’re better off holding it than switching into another unless you have extremely high conviction. Consider, for instance, a $100 investment that earns 10% per year. If you sell after a year and then invest the capital in another investment that earns 10% per year, then in the first year you turn $100 into $108, and then in the second year you turn $108 into $116.64. But if you hold one investment that earns 10% per year it goes from $100 to $110 to $121. You then pay taxes on $21 at 20%, bringing your total down to $116.80. This 16 cent difference doesn’t look like a lot, but the implication is that the longer you hold an investment the more you let it compound without paying taxes on the profits. Over 2 years the difference isn’t a lot, but over 10 years it is.

Disclosure: None

More from Wall St. Cheat Sheet: