Tax Planning With Your Investments

HOW TO LEGALLY STIFF-ARM THE IRS
by Alex Green
"Be wary of strong drink. It can make you shoot at tax collectors - and miss."
- Robert Heinlein
Arthur Godfrey once said, "I'm proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money."
If you are an investor - paying taxes not just on your income but on dividends, interest and capital gains, as well - you could probably be just as proud for a whole lot less than that.
Fortunately, there is a simple way for investors to keep their annual tax bite to an absolute minimum - and legally stiff-arm the IRS.
You simply need to "tax-manage" your investments.
For example, mutual funds are required by law to distribute over 90% of their realized gains each year. You can get hit with a big tax bill even if you haven't sold a share.
How? Inside the fund, the manager may be buying and selling like mad, turning over the entire portfolio in less than a year. While this doesn't necessarily hurt his annual bonus, it can have a dramatic effect on your real-world returns. After all, you may owe taxes on all those short- and long-term capital gains, even if you haven't sold a single share.
Lipper, a global leader in fund information and analytical tools, recently published a study, Taxes in the Mutual Fund Industry - 2007: Assessing the Impact of Taxes on Shareholder Returns.
It found that taxable mutual fund investors surrendered at least $23.8 billion to Uncle Sam in 2006, just for buying and holding their funds!
Taxes gobbled up 15% of the gross return of the average U.S. diversified equity fund. And the tax hit was even worse for the average U.S. taxable bond fund. Here 38% of the gross return was lost to taxes, nearly double the cost of operating expenses and loads combined.
If anything, this study may have actually understated the tax costs. Why?
Because it included the 2000-2002 bear market in stocks, so tax-loss carry-forwards (and favorable changes in the tax code) actually mitigated the tax burden.
If you are voluntarily surrendering thousands of dollars to the IRS each year, you may feel like your investment portfolio is on a slow boat to China. Fortunately, you can tax-manage your portfolio to increase your real-world returns.
It's not difficult. Here's what you need to know...
Your annual tax liabilities will depend on both your tax bracket and how much of your portfolio is held outside of qualified retirement plans. I'm going to run through a few different scenarios, allowing you to easily adopt the strategy that is closest to your own personal situation.
Let's start with the easiest scenario. If all your long-term money is in a tax-advantaged account like an IRA, Keogh, 401(k), 403 (b), private pension plan or annuity, you can stop sweating.
You're safe from the taxman until you begin making withdrawals. So if all your long-term money is in a qualified retirement plan, you're already home free.
But, if you're like most investors, your personal situation is probably a little more complex. You likely have liquid assets both inside and outside of retirement accounts. In that case, you will need to tax manage your investment portfolio.
The first order of business is to place the right investments in the right accounts for maximum after-tax returns. You'll need to put your most tax-inefficient holdings into your tax-deferred accounts and the remaining holdings in your taxable accounts.
For example, real estate investment trusts (REITs) are highly tax-inefficient. Most of your return will come in the form of dividends and these are taxable at your income tax rate, not the 15% rate for corporate dividends.
Another tax-inefficient asset is high-yield bonds. Here the majority of the return comes from interest income - and all of it is taxable. A junk bond fund will typically make capital gains distributions from time to time, as well. So you want to place these in your tax-deferred account, if possible.
Also highly tax-inefficient are inflation-protected securities (TIPS). The semi-annual interest payments on TIPS are taxable, the same as other Treasury securities. However, investors are also taxed on inflation adjustments to the principal, a situation that is commonly described as taxing "phantom income." For these reasons, you should also hold your inflation-adjusted Treasuries in your tax-deferred account.
High-grade corporate bonds and ordinary Treasuries pay taxable income, too. They, too, should be held in your tax-deferred account.
On the other hand, individual stocks are highly tax-efficient. You control when you decide to take profits, so you can control your tax liability.
And long-term capital gains are taxed at a maximum rate of 15%, regardless of your tax bracket. (Although Mr. Obama wants to change that.)
Stock index funds are fairly tax-efficient, with one exception:
small-caps. If a small company is successful and keeps growing, it will reach the point where it is no longer a small-cap stock. At that point it will eventually be removed from the small-cap index. When a small-cap index fund sells a small-cap that has become a mid-cap, it will generate a realized capital gain. That gain, of course, will be distributed to shareholders.
So be careful where you place the assets you own.
Money managers and financial planners often talk about the importance of asset allocation. Tax-managing your portfolio is what I call your asset "location" strategy. It's simply a matter of owning your least tax-efficient assets inside your retirement account and your most tax-efficient ones outside them.
Don't think for a minute that this isn't worth the trouble. Effective tax-management of your portfolio is critical - and can dramatically increase your real-world returns.
If you're not doing everything possible to minimize your investment costs and taxes, you're operating at a serious disadvantage.
As investment legend John Templeton famously said, "There is only one investment objective: maximum total return after taxes."
As a financial writer, I write and speak about this topic all the time.
Occasionally, this strategy provokes anxiety from some do-gooders who see tax-management strategies as some sort of abdication of civic responsibilities.
Nothing could be further from the truth. As a law-abiding U.S. citizen, you need to pay the taxes you are obligated to pay...and not one penny more. As Judge Learned Hand, who served for years as Chief Judge of the U.S. Court of Appeals for the Second Circuit, famously wrote:
"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury. There is not even a patriotic duty to increase one's taxes. Over and over again, the courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike, and all do right, for nobody owes any public duty to pay more than the law demands."
Amen, Judge.
As Vanguard founder John Bogle has said, "Fads come and go and styles of investing come and go. The only things that go on forever are costs and taxes."
In short, taxes matter...a lot. Take the basic steps I've outlined here to tax-manage your portfolio and you're assured of higher real-world, after-tax returns.