Tax Efficient Investing

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Tax Efficient Investing: How to Calculate Total Return and 4 Ways to Tax-Manage Your Investment Portfolio

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, December 10, 2007: Issue #740

Some investors seek long-term growth. Others are looking for income. But what all investors should really be interested in is maximizing their total return.

What is your total return? Here’s a simple formula. Total Return = return on invested capital + dividends and interest – investment expenses – taxes.

We spend most of our time here talking about how to increase your gross returns. Today let’s look at how to increase your net returns, by practicing tax efficient investing.

In my former life as an investment advisor, I was surprised to see how many investors were oblivious to the tax consequences of their investment decisions.

Big mistake. If you’re not careful how you invest, you can turn over many tens of thousands of dollars to the IRS over your lifetime… voluntarily.

4 Ways to Practice Tax Efficient Investing

Here are four simple steps you can take to “tax-manage” your investment portfoli

1. Minimize turnover. Taking short-term capital gains means subjecting yourself to short-term capital gains taxes as high as 35%, depending on your tax bracket. As Warren Buffett once said, “The capital gains tax is not a tax on capital gains, it’s a tax on transactions.” Hold winners for at least a year, if possible. If you do, you’ll qualify for long-term capital gains treatment at the maximum rate of only 15%.

2. Offset even these gains with capital losses. The IRS allows you to offset all of your realized capital gains with realized capital losses. And you can take up to $3,000 in additional losses against earned income. This is the season to do it, too. If you want to take the deduction for 2007, you need to sell your losers by the end of this month.

3. Use your IRA, pension, 401(k) or other tax-deferred account to own bonds (since interest income is taxed at the same rate as earned income) and real estate investment trusts (since REIT dividends are taxed that way, too).

4. Use index funds rather than actively managed funds in your non-retirement accounts. Index funds tend to be highly tax-efficient because changes to the index are rare. Managed funds often have high turnover and Federal law requires them to distribute at least 98% of realized capital gains each year. You can get hit with a big capital gains distribution even when you haven’t sold a share and even if the fund is down for the year. That hurts on April 15.

Take these steps and you will substantially lessen the government’s tax bite on your portfolio. The few remaining choices are simple ones – like owning tax-free rather than taxable bonds if you reside in the upper tax brackets.

Other Ways to Minimize Your Tax Burden

If you’re looking to reduce your taxes further, consider investing in fine art and donating it to a charity. The 1995 Tax Act allows you to donate to any IRS-approved charity works of art at their fair market value, not at their cost basis. Moreover, you can deduct the charitable gift’s fair market value on your return without being subject to the dreaded alternative minimum tax.

This is not just for fat cats, by the way. You can invest in art with just a few thousand dollars. (For more information, feel free to contact Mike Kuschman, president of Fine Arts Ltd, at 800.229.4322 or 407.702.6638.)

Most importantly, be aware of the tax implications of all your investment moves.

Don’t get me wrong. Taxes should not be your first consideration. But they are an important one.

Whenever I write on this topic, I invariably get a few e-mails from folks telling me that keeping the IRS at bay is un-American or unpatriotic. Baloney.

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.

Alex

Today’s Investment U Crib Sheet – Did You Know…

You can write off prescriptions, laser surgery, acupuncture, childbirth classes and even taking a taxi to your doctor’s office? Our most recent article on tax-managing your portfolio shows you how to save even more money this year by taking advantage of some little-known deductions.