Tax Savvy Investing: 5 Tips

Knowing how and when Uncle Sam gets his cut of your portfolio income will help you better select and time investment purchases

As anyone who has every signed a tax return knows, it's not how much you make, it's how much you keep--after taxes. Consider taxes on investments -- knowing how and when Uncle Sam gets his piece of your portfolio income -- will help you better select and time stock and bond purchases.

To help you become a more tax-savvy investor, I've put together five rules that ought to frame your investment selection process. After all, why opt for a high-risk investment that's subject to a high tax, when a low-risk, low-taxed investment may yield nearly as much or more?

Whether it's stocks, funds, commodities, real estate, coins or art, when you profit by selling a piece of your portfolio, Uncle Sam wants his cut. That cut is called a "capital gains tax." How much you're taxed depends on how long you've held on to a particular investment. If you've held the investment for more than 12 months, the IRS won't take more than 20% of your profits, and thanks to new rules effective in 2001, as little as 8% for taxpayers in the 15% bracket who have held their investments for 5 years. Whatever your income, you'll always pay less tax at the capital gains rate than at your regular bracket so it pays to hold your investments for at least a year. Capital ownership for less than 12 months results in a "short-term" rather than a "long-term" gain and is taxed at your regular bracket.

Believe it or not, there is a silver lining to bad investing -- and from the IRS, no less. When you sell a losing investment, you get a tax break. You can deduct the loss from your capital gains. Long-term losses are deducted from long-term gains, and short-term from short-term gains. And if you have more losses than gains, you can deduct losses from your personal income. But Uncle Sam's forgiveness taps out at $3,000 in losses per year.

Income is income -- whether it's your salary, annuities from bonds, interest from a certificate of deposit or dividends from stock that you hold. It all gets taxed as ordinary income the year the investments pay out. Even if you choose to reinvest the interest, you still get taxed on it. It's no different than deciding to invest some of your wages.

An exception: Municipal bond income is tax-free. The federal government is under a Constitutional mandate that forbids it to tax the states, which translates into no federal taxes on your municipal bond income. And states make their bonds tax-free (to their own citizens) as an incentive to lend money to municipalities. Sure, if you buy a municipal bond issued in a state in which you do not reside, it will be state taxable, but it's still federally tax-free.

An exception to the exception: Bonds issued by Puerto Rico are state and federally tax-free to all U.S. citizens, no matter where they live.

By now you may realize that the tax treatment of investments is a matter of rewards given by our government to encourage or discourage you from making certain investments. And our government supports the great American dream of home ownership. As many homeowners know, land taxes and mortgage interest payments are deductible each year -- reducing your taxes while you own the residence. And when you're ready to sell, up to $250,000 of the gains from your primary residence -- one in which you resided for at least two of the past five years prior to sale -- is entirely tax-exempt ($500,000 per couple). You can therefore sell a residence every two years and take the tax exclusion.

Mutual funds that hold stocks or bonds are subject to capital gains rules. Even if you do not sell your funds, the gains in the fund resulting from the manager's buying and selling stocks and bonds are passed on to you each year. If you're thinking of buying a fund, you'll want to wait until after the tax assessment is made, or you'll end up paying taxes on funds that have not actually risen in value since you bought them. Capital gains tax assessments are usually made in December (call your fund managers for specific dates).

Although the interest from municipal bond funds is tax free, if you sell your shares at a gain, you'll owe taxes on the profit. Real estate investment trusts (REITs), which are similar to mutual funds, own income-producing real estate, like hotels and apartment houses. Their income is paid out to you and you're taxed on that disbursement at ordinary income rates. If you sell your REIT shares for a profit, you pay a capital gains tax.


Now that you have the five key rules of the game, your next move is adding this information to your investment decision-making process. So before you buy your next stock or fund or whatever, project the return you expect from the investment, then calculate its after-tax return. Only in this way can you determine its real value to you. How do you do this? Here's a basic formula for investments: Real return = (100 - your tax rate) x capital gains or interest

To compare a taxable bond to a tax-free bond, for example, use this formula:

Taxable Bond: Expected returns = (100 - your tax rate) x interest earned

Tax-Free Bond: Expected return = 100% of interest earned

You are better off with whichever of the two expected return figures is greater.

Today, many of our assets are held in tax-qualified plans like IRAs, 401ks, 403bs and Keoghs. The assets grow, tax-deferred, until we take them out at retirement. This growth is very powerful because it is reinvested without being diminished by taxes along the way.

Don't forget tax consequences when you're deciding which investments to hold in your retirement accounts and which to hold outside (in regular accounts). A mutual fund manager who buys and sells stocks actively is likely to generate hefty capital gains distributions. Your retirement plan is a good place for these funds because you won't have to pay taxes on the distributions until you withdraw the money in retirement. You may be in a lower tax bracket then and even if you're not, you've made Uncle Sam wait for the taxes. On the other hand, tax-efficient funds like index funds are ideal candidates for your regular portfolio (outside of IRAs, 401(k)s, etc.) because they tend to spin off less income and capital gains distributions each year. The growth stays in the fund and you can postpone most of the tax burden until you sell your shares.

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