Tax Smart Investing

For many investors, it isn't what you earn that counts — in the end it’s what you keep that matters. While taxes are inevitable, there are a number of long-term, tax-smart investing strategies that may help you keep more of what you earn.

Our Top Ten Tax Tips

  1. Before buying or selling an investment, understand the tax implications. 
  2. When shopping for a fund, look at its portfolio turnover rate. 
  3. Consider tax-managed funds, index funds, or funds that follow a buy-and-hold strategy. 
  4. Take full advantage of tax-deferred investment vehicles. 
  5. Pay attention to the type of investments you select for your tax-deferred and taxable accounts. 
  6. Consider taxes when purchasing bond funds, even municipal bond funds. 
  7. Be aware of a fund's annual distribution date. 
  8. Manage your gains as well as your losses. 
  9. Talk to a tax advisor about tax-loss selling. 
  10.  Beware of the Alternative Minimum Tax (AMT).

Strategies to Minimize Taxes and Get the Most from Your Investments

While we are happy to review some tax-smart investment strategies, it’s important that you consult your tax advisor before making investment decisions in an effort to lower your tax bill and enhance your after-tax returns.

Choose the Right Type of Investment

Some investments are taxable, some tax-free, some tax-deferred and some tax-efficient. It’s important to make sure you are choosing the right type of investment for various accounts. Investments that generate taxable income, such as taxable bond funds or stock funds, may be better held in tax-deferred accounts — such as your IRA. Save the municipal bond funds or tax-sensitive investments for your regular, taxable accounts.

Then, make sure you're taking full advantage of tax-efficient investments. For instance, municipal bond funds generate income that is free from taxation at the federal level and, in some cases, the state and local levels as well. Other tax-smart investments include tax-sensitive mutual funds, and index funds or Exchange Traded Funds (ETFs), which typically utilize a buy-and-hold strategy.

Tap the Power of Tax Deferral

Tax deferral simply means that you postpone the payment of taxes until a later date — usually when you withdraw your money. This keeps your money working, and earning more, rather than going to pay taxes each year. It may not seem like much, but it can make a big difference in helping you achieve your financial goals.

There are a number of tax-deferred savings vehicles available to you as an investor, such as IRAs, 401(k)s, 403(b)s and 529 plans. Remember, you generally will be subject to taxes at the time you withdraw assets from a tax-deferred account.

Save for Tomorrow, Today

Retirement may seem far away, but starting early is crucial. Even if you can only save a small amount each year, you'll be better prepared to live comfortably in retirement. If you wait, you'll have to save much more each year in order to save the same amount and have enough money to retire at the age you'd like. Here’s a brief look at some of your retirement saving options.

 

  • Company plans: If you are eligible for an employer sponsored retirement plan, such as a 401(k) or 403(b), sign up as soon as possible and try to contribute the maximum allowed to the plan, or at least enough to take advantage of your employer's matching contributions, if available.
  • IRAs: As long as you or your spouse has income from work, you may be eligible to contribute to an IRA. And depending on whether or not you have a company-sponsored plan, those contributions may be tax-deductible. Regardless, all earnings will grow tax-free.
  • Annuities: An annuity may be right for investors who aren't eligible for a traditional IRA or a Roth IRA. This alternative retirement investment offers tax-deferred growth during the accumulation phase with a wide range of investment options.
  • SEP IRA for small business owners: Small business owners, or employees of a small business, might consider a SEP IRA. Sole proprietors can contribute up to 20% of their profits from self-employment, and owners of incorporated businesses can contribute up to 25%. For employees contributions to SEP-IRAs are treated the same as those to an IRA.

An early distribution from a traditional IRA prior to age 59½ may be subject to a 10% excise tax penalty.10% federal income tax withholding (and any applicable state withholding) may also apply. Please consult your tax advisor to determine if an IRA is a suitable investment for you.

Manage Your Gains, and Losses

Make sure you are aware of a fund’s annual distribution date. If you buy shares right before capital gains are distributed, you will receive a distribution and have to pay tax on gains earned throughout the entire year, even though you are a new investor.

Further, when it comes time to sell, you may, or may not, wish to wait for distributions to be made. This will depend on the size of the gain, whether or not you are selling at a loss, and your tax strategy.

If you have investment losses, you may be able to offset them with your investment gains each year. Tax-loss harvesting can help reduce your income tax liability, particularly for investors in the highest income tax brackets. In fact, if your losses exceed your gains, you might also be able to offset up to $3,000 in earned income.

Beware of the AMT

The Alternative Minimum Tax (AMT) was created in the late 1960s to prevent very wealthy people from living tax-free. However, because it was never indexed for inflation, many middle-income taxpayers are finding that they also owe the AMT — particularly if one or more of the following apply:

  • Several children
  • Interest deductions from second mortgages
  • Interest from specified tax-exempt private activity bonds
  • High state and local taxes
  • Realized gains on incentive stock options

If you are already affected by the AMT, or are close to it, speak with a tax advisor or other professional to find out what steps you can take for better AMT planning.

 

Transfer of Wealth

For taxpayers who itemize their deductions, there may be a way, if appropriate to write off your charitable gifts. Instead of giving cash to your favorite charity, consider donating stocks that have substantially appreciated in value. This way, the cost of your donation is the lower, original purchase price, but you can deduct the higher, current market value of the stock — and you won't be hit with any capital gains taxes.

How Fund Investment Strategies May Affect Your Taxes


There are several ways an investment can impact your tax bill. Choose the right investment for your taxable accounts and make sure you understand the tax implications.

It’s important to choose the right investment for your taxable accounts because there are several ways an investment can impact your tax bill: the kinds of securities the fund invests in, the portfolio's turnover rate and the fund's investment policies. All these factors can come together to create capital gains and income dividends that are taxed in varying ways.

What is a capital gain?

Mutual funds invest in a variety of securities and when they sell those securities at a higher price, they realize a profit. They pass these gains onto shareholders in an annual distribution.

  • Short-term gains are made when an investment is sold within the first year of purchase, taxed at a rate of up to 37%.
  • Long-term gains are from investments that are held longer and are taxed at a lower rate of 15%.

Further, when you sell your shares, you may realize a profit (or loss). If you make a profit on some investments, and a loss on others, you may be able to use those gains to offset your losses and pay lower taxes. If your losses are more than your gains, you may be able to apply those losses against other income, up to $3,000.

What is an income dividend?

Many investments, typically bonds but some stocks as well, pay income to shareholders, called dividends. Any interest income generated by securities in a fund's portfolio is paid to shareholders on a per-share basis at regular intervals, typically monthly or quarterly.

  • Qualified dividends are typically taxed as long-term capital gains.
  • Ordinary or non-qualified dividends generally include all taxable income except long-term capital gains and are taxed at your income tax rate.
  • Tax-exempt interest income from municipal bonds is generally exempt from federal income taxes. State and local municipal bonds may be exempt from state and/or local taxes.
What are the chances your fund will generate taxable income and capital gains?
Type of Fund Potential for Federal Taxable Income Potential for Capital Gains
Taxable money market High Very Low
Tax-exempt money market Very Low Very Low
Taxable bond High Low
Tax-exempt bond Very Low Low
Balanced (stocks and bonds) Medium to High Medium to High
Growth and income stock Medium to High Medium to High
Growth stock Low High
Value stock Low High

 

Money market funds pay ordinary dividends. Whether these dividends are taxable depends on the nature of the underlying investments: municipal securities produce income that is generally not subject to federal income tax and, in a state-specific fund, may also be exempt from state and local taxes. Because money market funds own only short-term securities, which are normally held to maturity, they do not ordinarily generate capital gains or losses.

Bond funds typically produce higher levels of income dividends (which may be taxable in whole or in part, depending on the fund’s investments). Further, because the prices of bonds fluctuate in response to changing interest rates as well as credit risk, it is possible to have taxable capital gain distributions from bond funds, even tax-exempt bond funds.

Stock funds may pass along ordinary income from dividends paid by stocks as well as capital gains from the sale of stocks. Because stock prices can fluctuate considerably more than bond prices, you are more likely to realize a larger capital gain (or loss) when selling shares of a stock fund. Further, certain investments and strategies can lead to potentially larger gains. To help gauge the potential tax impact, know your fund's objective and investment strategy:

  • Older, larger and well-established companies tend to rise in price more steadily over the long term, whereas newer or smaller companies can be more volatile and experience wider or more accelerated jumps in price.
  • Growth funds, which look for companies that managers believe will experience faster than average growth, tend to offer a higher potential return and perhaps higher capital gains. Funds that concentrate on value stocks buy when prices are depressed with the expectation of significant growth. They tend to produce more current income than growth funds and, should the market recognize the true value of the stocks in which they invest, potentially high capital gains.
  • Some funds have a high portfolio turnover rate, actively buying and selling shares. Frequent selling can make the fund more likely to produce annual taxable distributions than one that follows a "buy-and-hold" strategy.

This information is general in nature and is not intended to constitute tax advice. Please consult your tax advisor for more detailed information on tax issues and for advice on your specific situation.

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