Saturday, September 13, 2014

Keeping Your Balance: The fundamentals of tax-efficient investing

Anthony G. Sandonato for the NYDailyRecord.com writes: As prudent investors know, it is 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 forty percent or more. Adding to this tax bite is the relatively new 3.8 percent Medicare Tax on net investment income that impacts high-income individuals, trusts and estates.

To see the impact of taxes on investing, consider that if you earned an average seven percent rate of return annually on an investment taxed at 28 percent, your after-tax rate of return would be 5.04 percent. A $50,000 investment earning 7 percent annually would be worth $98,358 after 10 years; at 5.04 percent, it would be worth only $81,756. Reducing your tax liability is essential to building the value of your assets, especially if you are in a higher income-tax bracket. Here are several ways to potentially help lower your tax bill and grow your investments.

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 pre-tax 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 Earnings that accumulate in Roth accounts can be withdrawn tax-free if you have held the account for at least five years and meet the requirements for a qualified distribution.

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 percent federal tax penalty. 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 percent, you will 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 is because withdrawals from tax-deferred accounts generally will be taxed at your ordinary income tax rate, which may be higher than your long-term capital gains tax rate.

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.

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.

Use tax loss harvesting to your advantage
At times, you may be able to use losses in your investment portfolio to help offset realized gains. It is 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 capital losses in a given tax year must first be used to offset realized capital gains. If you have “leftover” capital 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.

A few down periods do not mean you should sell simply to realize a loss. Stocks in particular are long-term investments subject to fluctuations. 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.
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.

Conclusion
When considering investment decisions, tax implications play an important role. While they should not be the only factor to consider, investing in a tax-efficient manner can significantly increase you returns and net worth over the course of your lifespan. 

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