Daniel Solin for The Smarter Investor/US News World Report writes: I have a
high regard for accountants. They have an extremely difficult job. In order to
maximize tax savings for their clients, they need to understand and interpret an
incredibly complicated Internal Revenue Code. Former U.S. congressman John
Hostettler
once said, “The
Internal Revenue Code and regulations add up to 1 million words and is nearly
seven times the length of the Bible.”
It's not
surprising that few accountants look outside the code for tax-saving
opportunities. That’s unfortunate. There’s a world of tax-saving
possibilities
related to investing. If your accountant is not familiar with them, your
registered investment advisor should be alerting you to them.
The
failure to focus on the tax efficiency of your investments
can significantly affect
your returns. According to a 2008 Vanguard publication, "Tax-Efficient
Equity Investing: Solutions for Maximizing After-Tax Returns," taxes
have the potential to
take the “biggest bite” out of total returns. How much of a bite?
According to research by Joe Dickson and John Shoven, “Taxes and Mutual
Funds: An Investor Perspective," taxes can reduce the returns of
a mutual fund by as much as a whopping 25 percent.
These tax
tips will help make you a more tax-savvy investor:
1. Harvest your tax losses. No one
is happy when their investment goes down in value. However, tax-loss harvesting
permits you to sell investments at a loss and use those losses to offset gains
on other investments. Here’s an example of how it works.
Assume
you purchased a fund for $10,000 on January 1 and it declined to $5,000 on
March 1 of the same year. If you decide to "harvest" the loss, it will
be characterized as a short-term loss since the fund was held for less than one
year. Assuming a 35 percent ordinary federal income tax, your tax savings would
be $1,750. You will have reduced your economic loss to $3,250.
Tax-loss
harvesting is not simple. Initially, it involves determining whether the
loss is substantial enough to harvest. You also need to assess the problem of
exiting the market and missing out on potentially large gains. You can avoid
this problem by complying with the "wash-sale" rule, which permits
you to sell a stock or mutual fund and buy a replacement stock or fund, as long
as the replacement is not considered "substantially identical" in
nature.
2. Invest in retirement accounts. Take
advantage of a 401(k) or 403(b) plan offered by your employer. The funds you
invest in these plans are pretax. You will defer taxes until you start
receiving distributions. Don't forget to contribute on your own to a
traditional individual retirement account or (if you qualify) to a Roth IRA. With a Roth, you will be
contributing with after-tax funds, but your withdrawals will be tax-free.
3. Allocate your investments. The way
you allocate funds between your taxable and nontaxable accounts can have a
meaningful impact on your after-tax returns. Funds that pay out meaningful
taxable distributions of dividends and capital gains should typically be placed
in a tax-deferred account. Taxable bond funds should also be placed in a
tax-deferred account. This will permit you to reinvest distributions and avoid
recognizing those distributions as ordinary income.
Real estate investment trusts
and most alternative investments should generally be held in tax-deferred
accounts to defer taxes on distributions.
Active
trading of your investments is generally a bad idea because it runs up
transaction costs, which reduces returns. However, if you must actively trade,
put those investments in a tax-deferred account so you can buy and sell without
tax consequences.
Individual
stocks that you intend to keep for a long time should be placed in an after-tax
account. Index funds and stock index exchange-traded funds are also good
candidates for your after-tax account.
When
deciding how to allocate investments between your taxable and nontaxable
accounts, taxes should not be your sole consideration. Investments in
tax-deferred accounts have restrictions on withdrawals. You may incur a penalty
if you withdraw these funds earlier than permitted. You want to be sure you
have enough funds in your taxable account so you can meet your needs, without
accessing your retirement accounts.
4. Buy index funds. As a
general rule, index funds (where the fund manager seeks to replicate the
returns of the designated index and there are less transaction costs) that track a broad
index (like the Standard & Poor's 500 index) and comparable ETFs are very tax-efficient. Most
actively managed funds (where the fund manager attempts to beat the returns of
the designated benchmark) trade more than index funds, incurring higher taxes. They
are less tax-efficient.
The same Vanguard study calculated the tax costs of
actively managed funds and index funds. The study measured the tax cost for 15
years ended Dec. 31, 2007. It found the median tax cost of domestic
actively managed funds was higher, by 0.83 percent annually, than the tax cost
for index funds.
This
significant difference in tax costs is a major reason why the same study found
that "indexing has historically provided higher after-tax returns than
have actively managed mutual funds.”
Here’s
the bottom line: If tax efficiency is important to you, consider investing in
index funds, ETFs or passively managed fund.
Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, "The Smartest Sales Book You'll Ever Read," has just been published.