What Investors Can Do to Minimize Taxes Next Year

"The Experts" @ The Wall St. Journal write: April 15 may have come and gone, but that doesn't mean it's too late to prepare for next year's tax season.With this in mind, we asked The Experts: What can investors do now to minimize the investment-related taxes they will owe next year?

 

Why Investors Should Focus on After-Tax Returns

GUS SAUTER : It's always important to think of the after-tax return when making an investment decision.  For some investors, that might mean investing their fixed-income allocation in tax-free municipal bonds. But, for other investors, not in the highest tax brackets, the better investment might be higher-yielding taxable bonds, and paying the tax bill.

Among equity investments, high-turnover active funds eat up return by incurring significant transaction costs and realizing capital gains and associated taxes on a regular basis.  These types of investments only make sense if the manager is able to add 2% to 3% extra return a year.  Please let me know if you find that animal. Most of them are extinct.

At the other end of the spectrum are index funds that realize little, or no, capital gains since they pursue essentially a buy-and-hold strategy.

If you are worried about future tax bills—and you should be—think about positioning your portfolio toward securities with the best after-tax returns for you. In your bond portfolio, you probably don't have significant unrealized capital gains, and you could move to municipal bonds if you are in a high tax bracket.

Your equity portfolio may or may not have large unrealized capital gains. If it does, consider allocating a portion of future investments to index funds. If unrealized gains are small, consider switching existing investments to index funds.

It's also important to consider asset location. In other words, put the most tax inefficient investments, such as taxable bonds, in a tax-deferred vehicle, like an IRA or 401k. More tax-efficient investments, like equities, can be placed in the taxable portion of your portfolio.

These moves will lighten your tax burden next year. However, as indicated above, it's important to think of after-tax returns. Sometimes it makes sense to pay incrementally higher taxes to get a higher return.

George U. "Gus" Sauter is a senior consultant to Vanguard Group From 2003 through 2012, Mr. Sauter served as Vanguard's chief investment officer.

Two Ways to Cut Investment-Related Taxes

TED JENKIN : We are in the thick of tax season and some of you who have completed your returns may have realized that your investment-related taxes went up last year. Most Americans are much more reactive than proactive when it comes to effective tax planning. There are various strategies you can deploy to minimize your investment-related taxes and here are two of my ideas to consider.

The $250,000 adjusted gross income (AGI) for married couples ($200,000 single) is an extremely important threshold to watch because it triggers the 3.8% Medicare surtax on "net investment income." This applies to taxable interest, taxable dividends, net taxable capital gains on investments, and net income from a rental property. Since it is early in the year, you will want to consider strategies that may keep your income below these levels if you are floating around the threshold. Considerations include maxing out 401(k) contributions, using a deferred-compensation plan if your company offers one, waiting on exercising stock options, health savings accounts and flexible spending accounts. This is not an end-all-be-all list, but a good place to start. Remember, the difference between capital-gains taxes of 15% and 18.8% isn't 3.8%. It's more than 25%!

Another option that many investors miss out on is matching up their capital gains and losses within their brokerage accounts toward the end of the year. Remember, if you have carried forward capital-gain losses from a prior tax year then you can sell positions that have gains essentially at a zero tax rate. At a minimum, if you have a fair amount of positive capital gains in 2014, just look for loss positions to at least wipe out some of the liability.

Ted Jenkin (@tedjenkin) is the co-CEO and founder of oXYGen Financial, a financial advisory firm focused on the X & Y generations. He also blogs at yoursmartmoneymoves.com.

How to Use 'Asset Location' to Cut Taxes

CHARLES ROTBLUT : Where you hold assets can significantly influence the investment taxes you will pay, a concept referred to as "asset location." The Internal Revenue Service gives investors considerable leeway in deciding what assets they hold in a taxable account and what they hold in a tax-deferred (e.g. a traditional IRA) or a tax-sheltered account (e.g. a Roth IRA). This allows you to use the tax code to your advantage.

Investments less likely to create a short capital gain or taxable income should be held in a regular brokerage account. Examples include long-term holdings, index funds and stocks paying qualified dividends. Municipal bonds should also be held in a taxable account because of the favorable tax treatment they receive.

Investments more likely to create a short-term gain or taxable income should be held in a traditional or Roth IRA. Examples include mutual funds with higher levels of turnover, stocks intended to be held for less than a year, real-estate investment trusts (their distributions do not qualify for the reduced dividend tax rate) and corporate bonds.

Some exceptions do exist regarding what you can and cannot hold in an IRA, so read IRS Publication 590 and consult a tax professional if you have questions.

Charles Rotblut (@charlesrotblut) is a vice president with the American Association of Individual Investors.

View Tax Liabilities Through a Wide Lens

LARRY ZIMPLEMAN : Benjamin Franklin said the only things certain in life are death and taxes. Tax planning certainly has a place as you think about investing and long-term asset accumulation, but you should never allow taxes to override the appropriate investment decision for you. After all, if you owe taxes, that means that you've generated some investment income—and isn't that the goal of investing? However, it's also true that you should only pay the appropriate or fair amount of taxes.

To make the right decisions around investment-related taxes, you need to take account of your entire investment portfolio and not each specific account. There may be investment losses or capital losses from other parts of your investment portfolio that can offset gains in other parts of your portfolio. And remember that some parts of your portfolio (like your 401(k) account or your rollover IRA account) don't pay taxes on the assets as they accumulate. If taxes and tax returns really aren't your thing, then you should visit with a financial adviser or accountant to get their advice on how to minimize any investment-related taxes.

Larry D. Zimpleman is chairman, president and chief executive of Principal Financial Group. PFG +0.27%

What You Can Do Now to Save on Next Year's Taxes

GREG MCBRIDE : To minimize the investment-related taxes you will owe next April, I'd be remiss if I didn't state the obvious: Fully use tax-advantaged retirement and college savings options before pursuing these goals in a taxable account.

Additionally, if you haven't rebalanced your taxable investment portfolio recently, consider harvesting some losses and using the proceeds to reallocate. Harvesting short-term losses can be used as an offset of up to $3,000 in income, which is taxed at a higher rate, while harvesting long-term losses can give you some latitude to match up a long-term capital gain at some later point this year without incurring a tax liability.

Greg McBride (@BankrateGreg) is senior vice president and chief financial analyst for Bankrate.com, providing analysis and advice on personal finance.

Why Muni Bonds Aren't Just for the Wealthy

RICK FERRI : Traditionally, municipal bonds have been viewed as an investment for people with high incomes. Currently, the yield-to-maturity on a 10-year AAA rated tax-free bond is almost as high as a 10-year Treasury note yield. On an after-tax basis, this makes municipal bonds more attractive to a larger number of investors.

Rick Ferri is founder of Portfolio Solutions LLC and the author of six books on low-cost index fund and ETF investing. His blog is RickFerri.com.

A Simple Strategy for Lower Taxable Income

MIKE PIPER : For most people, the biggest investment-related action they can take to cut their taxes is to simply contribute more money to their retirement accounts. As of 2010, according to the Center for Retirement Research at Boston College, only 6.7% of retirement plan participants contributed the most they could to their 401(k) plans.

In most cases, saving for retirement via a taxable brokerage account doesn't make sense unless you've already maxed out your retirement plan at work (if you have one) and an IRA. Even if the investment options in your 401(k) are lackluster, the tax advantages are typically sufficient to outweigh suboptimal performance, given that you can roll money from a 401(k) into an IRA after leaving your employer, at which point you can invest the money in almost any way you choose.

For those few people who are already maxing out their retirement accounts and who also have significant assets in taxable brokerage accounts, there are several things you can do throughout the year to minimize investment-related taxes. For example:

- Keep turnover to a minimum in most cases, thereby deferring taxation and ensuring that most of your gains will be taxed at long-term rates rather than short-term rates.

- Look for tax-loss harvesting opportunities (or tax-gain harvesting opportunities, if you're in the 15% tax bracket or below).

- Keep tax-inefficient assets out of the taxable accounts. For example, if you want to hold high-yield bonds, REITs, or actively managed mutual funds with very high turnover, it's typically best to do so in retirement accounts.

Mike Piper (@michaelrpiper) is the author of the blog ObliviousInvestor.com. He is also the author of several personal-finance books, including his latest, "Social Security Made Simple."

Three Simple Tax-Savings Tips for Investors

MICHELLE PERRY HIGGINS : Most of us know with a fair amount of certainty that we will have to pay taxes in the future. The question is how much. By planning ahead, you may be able to lessen your investment-related tax burden by a considerable amount. Here are three simple tax-savings tips for investors with taxable accounts.

1. Mutual funds pay out capital gains and income, creating potential tax liability. Be tax efficient by putting different kinds of investments in different kinds of accounts. Consider index funds in your taxable accounts because they have very low turnover and therefore lower capital gains distributions. Position the tax-inefficient assets with high turnover ratios (e.g. real-estate investment trusts) or any interest or dividends that do not get favorable tax treatment to your retirement accounts.

2. Monitor and track your cost basis throughout the year. A wise investor will know their estimated capital gain or loss on each investment, enabling them to offset a capital gain on one investment by selling another at a loss, (i.e. tax loss harvesting).

3. Track your investment purchase dates. If you sell an investment before holding it for one year plus one day, it is considered a short-term capital gain. Short-term gains are treated as ordinary income, taxable at the taxpayer's highest marginal rate.

Michelle Perry Higgins (@RetirementMPH) is a financial planner and principal at California Financial Advisors.

ETFs: a Tax Saver's Best Friend

GEORGE PAPADOPOULOS : I am a big fan of exchange-traded funds (ETFs) in taxable accounts because they are even more tax efficient than index mutual funds due to their unique structure. Being invested in ETFs will go a long way toward lowering taxes next year and every year.

Investors should be aiming to contribute as much as they can into their employer retirement plans. You get an immediate tax deduction, tax deferral for years, and possibly some free money in the form of matching funds.

In addition, investors should always be on the lookout to take advantage of the "tax-loss harvesting" technique. When an investment in a taxable account drops temporarily, we can wait passively for it to come back or we can swap it for a similar investment to realize the loss for income-tax purposes. The loss will offset any capital gains present in the same year. If you have more losses than gains, the loss will offset other income by as much as $3,000 and the excess (if any) will be carried forward to future years to offset the likely gains. Due to the strong bull market that we have experienced in the past five years, we are, oddly, having virtually no losses to take advantage of this technique.

George Papadopoulos is a fee-only wealth manager in Novi, Mich., serving affluent individuals and families. You can follow him at twitter (@feeonlyplanner), connect with him at Google+ or visit his firm's website.