Ways to Cut Uncle Sam's Tax Bill
Preserving your wealth is the name of the game and how you invest your money will make you either a winner or a loser. At this time of year, many people want to know what they can do different to make next years tax bill look smaller than the one they are looking at right now. The man with the smallest tax bill is the winner of this game. Let's review some ideas that might help.
Frequent trading comes to mind first and we all know the implications of this. Much of the estimated 2.5 percentage points of return a year lost to taxes, which domestic stock funds lost over the past decade can be blamed on manager's frequent trading. This is not news to you, so besides the well known 401(k) s and IRAs you can read about in the archived articles on this site, a few new tips might be of value.
If you own bonds in your portfolio, tax-free municipals might be a better choice than taxable alternatives like Treasuries. Munis gives you a shot at higher returns once you factor in the tax savings. Munis is in no way guaranteed to outperform but budget surpluses will most likely push the Treasury to shrink the supply of Treasury bonds. A smaller supply of Treasuries would hold down Treasury yields, which in turn makes munis more attractive.
Index funds need to be recognized for their high tax-efficiency. These funds are efficient due to their low portfolio turnover. Most stock fund managers are constantly trading securities. When these funds are profitable, they create taxable short and long-term gains. Funds must distribute these gains to shareholders that must pay taxes of up to 39.6% for short-term gains and up to 20% for long-term gains. Key: Index funds generally buy and hold the stocks of whichever index they follow, they have a lower turnover rate than actively managed funds. Have you heard this somewhere before? Yes, this translates into fewer taxed capital gains and smaller taxable distributions to shareholders. The only way an index fund should realize capital gains is if the manager has to sell stock to raise cash for investors redeeming their shares or the fund's portfolio needs rebalancing to reflect a change in the underlying index. Newly introduced ETFs are a new type of investment that we can't go into here but are another way to get tax efficiency with index funds. This might be something to investigate.
Another way to look at losses
Low turnover being the saying of the day, another phrase "tax-managed funds" is something to aquaint yourself with. Tax-managed funds purposely try to minimize or even eliminate taxable distributions. The managers emphasize on stocks with low or no yields, which means reduced dividend income. Buy and hold, applies here. The point is fewer realized gains and those it does have tend to be long term and lower tax rates. Managers may even sell some stocks for losses, which they later offset against gains in other stocks. These losses are tax shields that are used to shelter future gains.
Buy and Hold
This strategy is one you hear all the time and for good reason. Purchase stocks that have long-term prospects and pay little or no dividends and hang on unless you just have to have the money. This way you are earning a rate of return on your money you would otherwise give up on April 15th. If you hold a stock longer than a year, any gain is then taxed at the maximum long-term capital gains rate of 20%. This sounds a lot better than 39.6%.
Tip: Buying companies with fast growing earnings are least likely to present you with taxable dividends.