Your Investing Gains Need Not Be Lost at Tax Time
There's an old Wall Street adage: "Never let the tax tail wag your investment dog." But you'd be foolish to ignore taxes altogether, since studies show that Uncle Sam plucks about 2 percentage points from the average investor's annual total return. So as tax season rolls around, consider the following steps to reduce your investment tax bills for the long run.
Put your investments in the proper accounts. The government gives most workers a tax shelter in the form of individual retirement accounts and 401(k)'s. Don't waste it. Use your IRAs and 401(k)'s for the investments that will expose you to the biggest tax bills. This includes actively managed stock funds and your taxable bond holdings. Tax-deferred accounts are also a great place to hold your real-estate funds, since most income generated by real estate investment trusts generally won't qualify for the beneficial 15 percent tax rate on dividends. As for your taxable accounts, use those to invest in low-tax investments, such as dividend-paying stocks, tax-efficient mutual funds, and tax-advantaged municipal bonds.
Reduce your mutual fund taxes. While fund investors "may not have cared about losing 1 or 2 percentage points to taxes in the late 1990s, they will care in an environment where expectations are for high-single-digit or low-double-digit returns," says Rande Spiegelman, vice president for financial planning at the Schwab Center for Investment Research. So stick with low-turnover funds, since funds that make few trades limit taxable capital gains. Index funds, which simply buy and hold all the stocks that make up a market benchmark like the Standard & Poor's 500, are an option. You can also consider tax-efficient mutual funds, which are specialized portfolios that buy and sell securities with taxes expressly in mind.
Harvest your losses. A simple way to reduce your capital-gains taxes is to sell stocks at a loss—and use those losses to offset gains elsewhere in your portfolio. While investors often hate to sell losing investments, harvesting losses is a good way to let Uncle Sam share in some of your defeats.
Rebalance with tax efficiency. Every year, investors are advised to rebalance their mix of stocks and bonds to get their holdings back in line with their long-term strategy. But instead of selling winning stocks and triggering taxes, consider using new money to add to an underperforming asset. Or, if you have to sell some investments at a gain, do so in your 401(k) or IRA—where sales don't trigger capital gains.
See if you belong in tax-free bonds. Ten-year treasuries are yielding around 4.5 percent. But if you're losing 33 percent of that to Uncle Sam, you're really enjoying an after-tax yield of only 3 percent. If you can find a high-quality municipal bond paying more than 3.1 percent, you may want to choose it instead. Muni bonds pay out less than treasuries, but they're free from federal income tax.
Keep track of your cost basis. If you reinvest dividends or capital-gains distributions, you're actually putting small amounts of new money to work throughout the year. This makes it extremely difficult to keep track of the cost basis of securities you eventually sell. So keep good records of all stock and fund purchases through reinvestment programs.
This story appears in the March 12, 2007 print edition of U.S. News & World Report.