Are you a tax-efficient investor?

Mercer Advisors writes: We are well aware of the ever-present existence of taxes in our financial lives. They impact our net income; they impact our net return within our investment portfolios; ultimately, they affect our lifestyle.

There are several things that you can do as an investor to ensure that less of your investment portfolio must be shared with Uncle Sam. What you keep is as important a factor as what you earn.

Maximize and optimize retirement contributions

First and foremost, whenever possible, contribute the allowed maximum to your retirement account each year because this will reduce your taxable income. Do you know what the 2013 maximum individual contribution limits are? See how close you are:

It is also important to confirm that you are taking advantage of all the retirement vehicles available to you and that you have the best type of retirement plan for your unique circumstances and objectives.

Pay attention to tax treatment and trading frequency

Beyond your retirement accounts, there are steps you can take that will help keep more of your investment earnings in your portfolio and out of Uncle Sam’s pocket.

Tax treatment is every bit as important as asset allocation (broad diversification of numerous asset classes, weighted specifically for your level of risk tolerance). Your tax-efficient holdings – such as municipal bonds and tax-managed stock funds – belong in taxable accounts as they are designed and managed to minimize tax consequences.

Municipal bonds are exempt from federal income tax, making them attractive for investors in higher tax brackets, as well as those interested in generating income. There are also a number of state-specific municipal bonds that are exempt from both state and local income taxes.

Tax-managed stock funds incorporate techniques designed to minimize the distribution of dividends and limit the buying and selling of holdings that would generate capital gains. With the passage of The American Taxpayer Relief Act of 2012 (ATRA), dividend and long-term capital gains tax rates increased from 15% to a maximum of 23.8% for investors in the top (39.6%) tax bracket. Short-term capital gains, taxed at ordinary rates, could have tax consequences of up to 43.4%.

Rebalance consistently and purposefully

It is important to rebalance your portfolio on a regular basis as market movement can cause your portfolio’s asset class allocation to deviate from its optimized composition. If left unattended, your portfolio could become either more risky or more conservative than you prefer – creating unwelcomed volatility or relinquished return.

Gains realized through the rebalancing of your retirement accounts have no tax implication as they are not subject to current taxes. When rebalancing taxable accounts however, it is beneficial to offset any potential capital gains through practices such as tax-loss harvesting or tax swapping in order to neutralize or minimize any tax consequence.

In a taxable account, there are tradeoffs to be considered with regard to rebalancing. You must decide which is more important for your unique circumstance:

• Rebalancing in order to maintain the designated risk/return profile for your portfolio
• Not rebalancing in order to delay the realization of capital gains (due to perhaps the sale of a business)

Weigh the best source for retirement income distribution

Once you enter retirement and rely on your investment accounts for your income stream, it is vitally important for you to know the tax ramifications tied to withdrawals from your taxable, retirement, and tax-free (Roth) accounts.

There is no tax consequence for withdrawals made from your Roth account as they were assessed when the initial contributions were made. Withdrawals made from a retirement account are subject to ordinary income tax rates; likely lower than when you were working, but perhaps still higher than capital gains rates. Taxable account withdrawals are subject only to capital gains tax rates.

The ability to assess market conditions, along with the varying life scenarios you will encounter and your monthly income needs, is an important component in determining the source of your retirement income stream.

Bottom line

A financial planner can provide you with a comprehensive analysis of your current investment and retirement portfolios, as well as advise you on planning for retirement income distribution – helping you make any necessary course corrections toward more tax-efficient investing habits.