Tax-Managing Your Investment Portfolio: There's Still Time to Cut Your Taxes

Alexander Green
by Alexander Green, Chief Investment Strategist, The Oxford Club

Tax-Managing Your Investment Portfolio: There's Still Time to Cut Your Taxes

by Alexander Green, Chairman, Investment U

Investment Director

Monday, December 1, 2008: Issue #894

Investment legend John Templeton insisted that everyone's long-term investment goal should be the same: maximum total return after taxes.

In my experience, investors spend plenty of time thinking about risk and return, but not enough about taxes. That's unfortunate. Especially since - unlike the stock market, interest rates or inflation - taxes are controllable.

Yet too many investors are surrendering far more to the taxman than they should. A Vanguard study, for example, found that the typical investor is giving up 2% a year to the IRS.

That's nearly 20% of the long-term return of the S&P 500. How can you stop this and still remain a law-abiding, civic-minded individual?

It starts with tax-managing your investment portfolio...

Tax-Managing Your Investment Portfolio - 5 Basic Steps

Here are the five basic steps for tax-managing your investment portfolio:

  • 1) Use your retirement account for short-term activity. If you like to trade for short-term profits, do it in your qualified retirement plan. That way all those short-term gains compound tax-deferred. (The downside in a bad market, however, is that losses in a retirement account are not tax deductible.)
  • 2) Minimize turnover in your non-retirement accounts. Realizing gains on investments held less than a year 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%.
  • 3) Offset capital 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. If you want to take the deduction for 2008, you need to sell your losers by the end of this month.
  • 4) Reduce your taxes on interest income. Use your IRA, pension, 401(k) or other tax-deferred account to own corporate and Treasury bonds (since interest income is taxed at the same rate as earned income) and real estate investment trusts (since REIT dividends are taxed the same way).
  • 5) Cut your management fees. If you invest in mutual funds, 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 investment portfolio. The few remaining choices are simple ones like owning tax-free rather than taxable bonds if you reside in a high-tax state like New York or California. (That is especially true today, since tax-free bonds are yielding more than Treasuries.)

While tax-managing your investment portfolio, if you're looking to reduce your taxes further:

  • Buy business equipment this month
  • Pre-pay businesses expenses for 2009
  • Fully fund your IRA, 401(k) or other retirement accounts.

Tax-Managing Your Investment Portfolio - Fine Art Donations

Consider investing in fine art and donating it to a charity to tax-manage your investment portfolio. 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, contact Mike Kuschman, president of Fine Arts Ltd, at 800.229.4322 or 407.702.6638.)

Too many investors are oblivious to the tax ramifications of their investment moves. Using the government tax breaks and tax-managing your investment portfolio can change that.

Tax savings should never be your sole consideration, however. In December 1996, for example, I sold my shares of Best Buy at a small loss, solely to offset some capital gains, then watched in horror as the stock rose nearly 30-fold over the next few years. (I still consider that one of my most bone-headed investment moves.)

Managing taxes is essential. It should be a priority. But it is not your most important one. Risk and return are your primary concerns. Taxes and expenses come next.

Focus on these four factors and your long-term investment success is virtually assured.

Good investing,


Today's Investment U Crib Sheet

"Two of the only sure things in life: death and taxes."

This year might go down as one of the worst on record for the market. What's more, mutual fund investors could be saddled with capital gains taxes, even as they report losses. Portfolios have been dropping by 30%, 60%, or more for many investors. But as the year comes to a close, that doesn't mean you should put your head in the sand as tax day approaches.

Last week, Alexander Green showed us in Investment U Issue #891, Exchange Traded Funds: An Investment Move You Need to Make... how to take advantage of our 2008 losses. It's a strategy to minimize your taxes. And it's one of our Four Pillars of Wealth. As we enter December, let's take another look at the most relevant Pillar.

Pillar 4: Always Look to Minimize Investment Expenses and Taxes

There's nothing we can do to affect a stock's performance once we own it. But there is a way for us to guarantee our portfolio will be worth more 5, 10, 20 years from now. All we have to do is cut our expenses... and stiff-arm the taxman (legally, of course). On the expense side, that means avoiding investments that carry front-end loads, back-end loads, 12b-1 fees, or surrender fees.

On the tax side, it means reducing what the IRS is entitled to take. We can do that by avoiding actively managed funds in non-retirement accounts, owning high-yielding investments in tax- deferred accounts and buying high quality investments (high-quality = less turnover = less capital gains taxes).

Follow the link to get all Four Pillars of Wealth.

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