Tax-Smart Investing

InvestNo one likes to pay taxes. Although they are one of the two certain things in life, you want to do all you can to reduce this burden. The ways to achieve that is through investing long term in mutual funds specializing in broad asset classes and using tax-managed funds.

Investors are subject to two forms of taxes. On bond interest, you pay ordinary income tax. In addition, if you sell your investments for a gain within a year of purchase, you pay tax at ordinary rates, too.

However, if you have a profit from selling a security held for more than one year, you get a lower rate, the long-term capital gains rate. For most taxpayers, it is no higher than 15 percent.

As you can tell from the preferential tax treatment for investors holding securities more than one year, investing for the long term is better.

We are a major proponent of asset class investing, where you invest in funds that give you exposure to large classes of similar stocks, such as large U.S. companies or small international developed market companies.

When you invest this way, you avoid trading in and out of securities, because you stand pat with your broad-ranging funds. The only time that you need to sell pieces of an asset class is when you rebalance your portfolio toward your target allocation.

For the fixed-income allocation, investors can use municipal bonds to get interest exempt from federal income taxes. In most states, bond income from the investors who live there is free from state taxes.

But are there ways to further reduce the tax burden? There are. While we use asset class mutual funds to potentially save taxes, we can use what is known as tax-managed funds, which aim to minimize tax costs in the investment process.

The managers of these funds keep the tax impact low by avoiding short-term gains. Some of the techniques include tax lot accounting (keeping a record of the purchase and sale price of each security to get the best tax treatment) and tax loss harvesting (selling a security at a loss to offset taxable gains).

The tax managed funds that we use also run quantitative models to evaluate the cost of executing a trade. All these strategic moves seek to lower investors? taxable income.

What we like about using the tax managed funds is their ability to adapt to the ever-changing tax code. The funds are able to make changes to their operating procedures to reflect new rules.

For investors in the higher brackets, paying fewer taxes is a substantial benefit. The next time you file your taxes, pay attention to the amount of long-term gains in your taxable portfolio versus short-term gains. Being smart about the tax consequences of investing can turn a good portfolio into a great one.

(Source: TNS)