Strategies to reduce your taxes

The most common mistakes an investor can make, especially a high-net-worth investor, is to overlook the potential impact taxes can have on investment returns. In fact, Morningstar cites on average, over the 74-year period ending in 2010, investors who did not manage investments in a tax-sensitive manner gave up between one and two percentage points of their annual returns to taxes.1 So as the following chart shows, a hypothetical stock return of 9.9% that shrank to 7.8% after taxes would, in effect, have left the investor with 2.1% less investment income in his or her pocket.

Taxes are not as inevitable as you might think. With careful and consistent planning, you can potentially reduce their impact on your returns through tax-efficient investing. Contact A.D. Financial Planning to help you make the right tax moves for your particular situation—or to confirm that your current approach is still sound. Below, are some possible tax-smart strategies to consider to help you prepare for a productive discussion with us.

20-year U.S. government bond. Inflation is represented by the Consumer Price Index (CPI), which is a widely recognized measure of inflation, calculated by the U.S. government. Please note that indexes are unmanaged and are not illustrative of any particular investment. It is not possible to invest directly in an index. © 2011 Morningstar, Inc. All rights reserved. 3/1/11.

Analysis of historical performance by the research firm Morningstar highlights the potential impact of taxes on investment performance. 1* Past performance is no guarantee of future results. This chart is for illustrative purposes only and does not represent actual or future performance of any investment option. Returns include the reinvestment of dividends and other earnings. Stocks represented by the Standard & Poor's 500 Index (S&P 500®). It is an unmanaged index of the common stocks prices of 500 widely held U.S. stocks. Bonds are represented by the 20-year U.S. government bond. Inflation is represented by the Consumer Price Index (CPI), which is a widely recognized measure of inflation, calculated by the U.S. government. Please note that indexes are unmanaged and are not illustrative of any particular investment. It is not possible to invest directly in an index. © 2011 Morningstar, Inc. All rights reserved. 3/1/11.

First, consider the accounts you invest in

Tax-free municipal bonds and money market funds

If generating income is one of your investment goals, you may want to consider tax-free municipal bond and money market funds, especially if you’re in a high tax bracket. These funds typically invest in bonds issued by municipalities and their earnings are generally not subject to federal tax. You may also be able to avoid or reduce state income tax on your earnings if you invest in a municipal bond or money market fund that holds bonds issued by entities within your state. Interest income generated by most state and local municipal bonds is generally exempt from federal income and/or alternative minimum taxes. But if these bonds were used to pay for such "private activities" as housing projects, hospitals, or certain industrial parks, the interest is fully taxable for taxpayers subject to the AMT.

Interest dividends distributed by a municipal bond or money market mutual fund are also subject to the AMT if the fund owns certain private activity bonds. A fund's prospectus will tell you if it aims to generate only AMT-free interest dividends.2

Tax-advantaged retirement savings accounts

Choosing the types of accounts in which to invest can be as important to tax efficiency as the types of assets you put in those accounts. When saving for retirement, a qualified workplace savings plan, such as a 401(k) or 403(b) plan, allows you to contribute pretax dollars that can potentially grow on a tax-deferred basis until they’re withdrawn after age 59½. If your employer offers a Roth 401(k), you can avoid taxes entirely on your earnings, provided certain conditions are met, although your contributions would not be pretax or tax deductible in the year you make them. Similarly, a Roth IRA allows your investments to grow tax-free, but there are income limits for contributions. If your income exceeds the limit and you or your spouse is not covered by a retirement plan at work, you may contribute to a traditional IRA for tax-deferred savings. Roth IRAs are now available to many investors and a new law allows workplace plan participants to directly convert certain plan assets in a 401(k) or 403(b) plan from a former employer to a designated Roth account, provided it is available in the plan. This may be good news for participants who are eligible for a distribution and want to keep their money in an employer plan rather than rolling it over to a Roth IRA.

If your employer offers you access to a health savings account (HSA) with a high-deductible health insurance plan, it’s a useful tool to potentially save on taxes while paying for qualified medical expenses.

Second, understand your asset allocation

Employing an asset location strategy

A well-thought-out asset allocation strategy can play a key part in helping to reduce a portfolio’s overall risk and boost reward potential. But there’s another important companion strategy that many investors often overlook. Known as “asset location,” it involves deciding which investments within your asset allocation are held in taxable, tax deferred, or tax free accounts. This strategy can potentially help reduce the tax impact. A.D. Financial Planning believes asset location is a key strategy in managing for tax efficiency, especially for affluent investors.

For example, you may want to consider whether it may be advantageous to give priority in your taxable accounts to relatively tax efficient investments, such as stocks or mutual funds that pay qualified dividends (as long as these rates remain in effect), equity index funds, and tax-managed stock funds. Similarly, it may make sense to use tax-deferred accounts such as defined contribution plans (401k, 403b, 457, etc.), traditional IRAs, and tax-deferred annuities for investments that generate high levels of ordinary income, such as taxable bond funds and real estate investment trusts (REITs), as well as, for any equity funds that tend to make large and frequent distributions of capital gains - particularly short-term capital gains.

Third, know when to hold or sell

Avoiding unnecessary short-term taxable gains

If you sell an investment within one year of purchasing it, you’ll likely owe more tax on your capital gain than if you held it for more than a year. So-called “short-term” capital gains are taxed at the same rate as your ordinary income, as much as 35% in 2010. The top tax rate on “long-term” capital gains is 15%. You should check to see if any of the investments you own may be worth holding for longer periods of time to avoid short-term capital gains. Of course, you should keep in mind the risk of holding these investments, and understand how they fit in your overall portfolio. If the risk outweighs the potential tax hit, it may make sense to sell. Additionally, check current tax rates for the right move; tax codes are constantly changing.

Offsetting capital gains with capital losses

Suppose you want to sell stock that has substantially increased in value in order to use the proceeds for a one-time expense, such as purchasing a vacation home or paying your grandchild’s college tuition. To offset a large tax liability on your capital gain, you could sell an investment that has lost value. But, if the losing investment was important to maintaining your portfolio’s asset allocation, you may want to purchase a different investment in the same asset category. Just be aware of wash sale rules that may prevent you from claiming a capital loss.

Capital loss carry-forwards

If your capital losses exceed your capital gains in a given year, you can generally deduct up to $3,000 of the excess from your ordinary income in that year. If you have more than $3,000 in excess losses, you’re able to carry forward those losses into future years.

These capital loss carry-forwards have considerable power to reduce future tax liabilities, especially during periods of extreme market volatility. Case in point: the market crash of 2008. If you were disciplined in harvesting your tax losses when asset values declined virtually across the board, you probably wound up with significant capital loss carry-forwards. You could have used those losses to offset gains you might have realized as the market rebounded from its lows in 2009—or possible gains in years ahead. But make sure you don’t forget about your carry-forwards, or you could lose them forever. Losses in your name alone are not passed along to your heirs.

Stay disciplined

Taking a tax-efficient approach to investing can be a smart move, but the real keys to potential success are staying disciplined and having a big picture perspective. Do not allow tax considerations to drive your overall investment objectives and long-term goals but you should understand the potential tax consequences of every transaction so you’re not generating unnecessary tax liability or unnecessarily lowering your investment returns.

To discuss wise tax investing, or just where to begin on your path to financial freedom, contact A.D. Financial Planning we are here to help.

1. Taxes can significantly reduce returns data, Morningstar, Inc. 3/1/2011. Federal income tax is calculated using the historical marginal and capital gains tax rates for a single taxpayer earning $100,000 in 2005 dollars every year. This annual income is adjusted using the Consumer Price Index in order to obtain the corresponding income level for each year. Income is taxed at the appropriate federal income tax rate as it occurs. When realized, capital gains are calculated assuming the appropriate capital gains rates. The holding period for capital gains tax calculation is assumed to be five years for stocks, while government bonds are held until replaced in the index. No state income taxes are included. Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Generally, among asset classes stocks are more volatile than bonds or short-term instruments. Government bonds and corporate bonds have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns. U.S. Treasury bills maintain a stable value if held to maturity, but returns are generally only slightly above the inflation rate. Although bonds generally present less short-term risk and volatility than stocks, bonds do entail interest rate risk (as interest rates rise, bond prices usually fall, and vice versa), issuer credit risk, and the risk of default, or the risk that an issuer will be unable to make income or principal payments. The effect of interest rate changes is usually more pronounced for longer-term securities. Additionally, bonds and short-term investments entail greater inflation risk, or the risk that the return of an investment will not keep up with increases in the prices of goods and services, than stocks.

2. Municipal bond funds normally seek to earn income and pay dividends that are expected to be exempt from federal income tax. If a fund investor is resident in the state of issuance of the bonds held by the fund, interest dividends may also be exempt from state and local income taxes. Such interest dividends may be subject to federal and/or state alternative minimum taxes. Investing in municipal bond funds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Interest dividends paid by Treasury bond funds are generally exempt from state income tax but are generally subject to federal income and alternative minimum taxes and may be subject to state alternative minimum taxes. Fund shareholders may also receive taxable distributions attributable to a fund's sale of municipal bonds. Fund redemptions, including exchanges, may result in a capital gain or loss for federal and/or state income tax purposes.

References: Reduce the tax hit on investments (2011). Retrieved April 20, 2012, from