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3 Ways to Cut Your Investment Tax Bill

Scrabble pieces spell out 'tax' on dollar bills

As tax season draws to a close for another year, you may be among those feeling the pinch from taxes paid on investments. I admit that paying taxes is not exactly my favorite thing, so I always look for ways to be more tax-efficient. Here are three things you can do to keep more of what you earn:

First, buy tax-efficient investments. Mutual funds that turn over stocks in the portfolio pass along any taxable gains to their holders. Many active funds buy and sell stocks so frequently that their average holding period is less than a year. Fund owners receive a Form 1099 from the mutual fund company that lists any short- and long-term capital gains. Both create tax consequences and short-term gains are generally taxed at a higher rate.

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Believe it or not, that can even happen in years when the fund’s value declined. A low-cost index fund such as the Vanguard Total Stock ETF (VTI) has very little turnover and allows investors to be in control of when or if they take the gain. Since it essentially owns every publicly held company based in the U.S., it doesn’t have to buy or sell stocks and rarely passes on any capital gains until you sell.

Second, keep  your assets in accounts that are the most tax-efficient. Tax-efficient funds, such as the Vanguard stock index fund mentioned above, belong in taxable accounts. Anything taxed at ordinary income rates, such as bondsCDs and  REITs (real estate investment trusts), generally should be held in tax-deferred accounts. Roth accounts are a bit more complicated because they are tax-free, which makes them much more dependent on each investor’s situation. Even here, an REIT often works since distributions (outside a traditional or Roth IRA) are taxed as ordinary income and REITs also offer more opportunity to grow than bonds. While everything coming out of a Roth is tax-free, both growth potential and shielding ordinary income tax are ideal for Roth accounts.

So to review, assets to place in tax-deferred accounts include:

  •    Bonds
  •    CDs
  •    REITs
  •    Stocks or stock mutual funds that trade stocks actively

Assets to put in taxable accounts:

  •    Low-turnover equity mutual funds
  •    Individual stocks held for long periods

Third, harvest your tax losses. Losses hurt and we don’t like to recognize them. But those losses have great value when tax time rolls around. I recommend selling anything at a loss and simultaneously buying a similar investment to avoid being out of the market. You also don’t want to run afoul of IRS rules. The rules say you can’t claim the loss if you buy it back within 30 days, calling it a wash sale. So, if your Vanguard Total Stock Index fund tanks, you can sell it and buy the Schwab Broad Market Index Fund (SCHB), which follows a similar U.S. stock index.

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I’ve always said that investing was simple, yet I’ve never said taxes were. There are many exceptions to the rules above in individual situations, depending on variables such as current and future income, tax-loss carryforwards and the like.

Remember that taxes are costs too, and tax-efficient investing is critical to building and maintaining a nest egg. Though we all like to pay less in taxes, the better goal is to make more money after taxes.

Photo: 401(k)2013/flickr

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