Reduce the tax hit on investments

Fidelity Viewpoints — 10/27/10

Strategies to potentially boost your after-tax returns.

There’s been an incessant buzz this year when it comes to taxes. Are they going up? Will they stay the same? Unless Congress acts soon, a multitude of taxes are likely to increase in 2011 for all investors–including those in high tax brackets–making the last few months of 2010 a potentially critical time to manage your investment income more efficiently. And with so much uncertainty in the air, it’s an important reminder to take time now to properly position your Taxes can significantly reduce returns portfolio for the future, no matter what happens.

One of the most common mistakes an investor can make is to overlook the potential impact taxes can have on investment returns. In fact, Morningstar cites on average, over the 74-year period ending in 2009, investors who did not manage investments in a tax-sensitive manner gave up between one and two percentage points of their annual returns to taxes. So, a hypothetical stock return of 9.8% that shrank to 7.7% after taxes would, in effect, have left the investor with 2.1% less investment income in his or her pocket.

Taxes, however, aren’t as inevitable as you might think. With careful and consistent planning, you can potentially reduce their impact on your returns through tax-efficient investing. We highly recommend that you consult with an experienced tax advisor, financial planner, or estate planning attorney to help you make the right tax moves for your particular situation—or to confirm that your current approach is still sound. But here are some possible tax-smart strategies to consider to help you prepare for a productive discussion with your advisor.

First, consider the accounts you invest in

Tax-free municipal bonds and money market funds. If generating income is one of your investment goals, you may want to consider tax-free municipal bond and money market funds, especially if you’re in a high tax bracket. These funds typically invest in bonds issued by municipalities and their earnings are generally not subject to federal tax. You may also be able to avoid or reduce state income tax on your earnings if you invest in a municipal bond or money market fund that holds bonds issued by entities within your state. Interest income generated by most state and local municipal bonds is generally exempt from federal income and/or alternative minimum taxes. But if these bonds were used to pay for such "private activities" as housing projects, hospitals, or certain industrial parks, the interest is fully taxable for taxpayers subject to the AMT.

Tax-advantaged retirement savings accounts. Choosing the types of accounts in which to invest can be as important to tax efficiency as the types of assets you put in those accounts. When saving for retirement, a qualified workplace savings plan, such as a 401(k) or 403(b) plan, allows you to contribute pretax dollars that can potentially grow on a tax-deferred basis until they’re withdrawn after age 59½. If your employer offers a Roth 401(k), you can avoid taxes entirely on your earnings, provided certain conditions are met, although your contributions would not be pretax or tax deductible in the year you make them. Similarly, a Roth IRA allows your investments to grow tax-free, but there are income limits for contributions. (For 2010, the phase-out ranges are $167,000 to $177,000 for joint filers and $105,000 to $120,000 for individual filers.) If your income exceeds the limit and you or your spouse is not covered by a retirement plan at work, you may contribute to a traditional IRA for tax-deferred savings. Roth IRAs are now available to many investors and a new law allows workplace plan participants to directly convert certain plan assets in a 401(k) or 403(b) plan from a former employer to a designated Roth account, provided it is available in the plan. This may be good news for participants who are eligible for a distribution and want to keep their money in an employer plan rather than rolling it over to a Roth IRA.

If your employer offers you access to a health savings account (HSA) with a high-deductible health insurance plan, it’s a useful tool to potentially save on taxes while paying for qualified medical expenses. And don’t forget about tax-deferred annuities. Taxes aren’t due on any earnings until they’re withdrawn in retirement, and there are no annual contribution limits,3 unlike an IRA or 401(k) plan.

Second, understand your asset allocation

Employing an asset location strategy: A well-thought-out asset allocation strategy can play a key part in helping to reduce a portfolio’s overall risk and boost reward potential. But there’s another important companion strategy that many investors often overlook. Known as “asset location,” it involves deciding which investments within your asset allocation are held in taxable, tax deferred, or tax free accounts. This strategy can potentially help reduce the tax impact.

For example, you may want to consider whether it may be advantageous to give priority in your taxable accounts to relatively tax efficient investments, such as stocks or mutual funds that pay qualified dividends (as long as these rates remain in effect), equity index funds, and tax-managed stock funds. Similarly, it may make sense to use tax-deferred accounts such as defined contribution plans (401k, 403b, 457, etc.), traditional IRAs, and tax-deferred annuities for investments that generate high levels of ordinary income, such as taxable bond funds and real estate investment trusts, as well as for any equity funds that tend to make large and frequent distributions of capital gains - particularly short-term capital gains.

Third, know when to hold or sell

Avoiding unnecessary short-term taxable gains. If you sell an investment within one year of purchasing it, you’ll likely owe more tax on your capital gain than if you held it for more than a year. So-called “short-term” capital gains are taxed at the same rate as your ordinary income, as much as 35% in 2010. The top tax rate on “long-term” capital gains is 15%. You should check to see if any of the investments you own may be worth holding for longer periods of time to avoid short-term capital gains. Of course, you should keep in mind the risk of holding these investments, and understand how they fit in your overall portfolio. If the risk outweighs the potential tax hit, it may make sense to sell.

Offsetting capital gains with capital losses. Suppose you want to sell stock that has substantially increased in value in order to use the proceeds for a one-time expense, such as purchasing a vacation home or paying your grandchild’s college tuition. To offset a large tax liability on your capital gain, you could sell an investment that has lost value. But, if the losing investment was important to maintaining your portfolio’s asset allocation, you may want to purchase a different investment in the same asset category. Just be aware of wash sale rules that may prevent you from claiming a capital loss.

Ongoing tax-loss harvesting. Tax-loss harvesting is the practice of selling investments that have lost value to offset current and future-year capital gains. Unlike one-time or occasional loss sales, however, a systematic tax-loss harvesting strategy requires diligent investment tracking and detailed tax accounting.

An effective tax-loss harvesting strategy involves continuous analysis of every tax lot (shares purchased at a given price and time) to determine when the tax loss benefit warrants selling appreciated positions. Trading a specific tax lot with a specific cost basis is different than selling all of your shares in a particular fund or stock, which may have been purchased at different times over many years and could have significantly different tax implications as a whole than they would individually.

If and when you decided to harvest your losses, you may want to consider replacing the lots you sold by investing in securities that have similar diversification and risk exposure characteristics, by being mindful of the wash sale rule, as previously noted.

Fourth, monitor deductions and distributions

Capital loss carry-forwards. If your capital losses exceed your capital gains in a given year, you can generally deduct up to $3,000 of the excess from your ordinary income in that year. If you have more than $3,000 in excess losses, you’re able to carry forward those losses into future years.

Loss carry forward

These capital loss carry-forwards have considerable power to reduce future tax liabilities, especially during periods of extreme market volatility. Case in point: the market crash of 2008. If you were disciplined in harvesting your tax losses when asset values declined virtually across the board, you probably wound up with significant capital loss carry-forwards. You could have used those losses to offset gains you might have realized as the market rebounded from its lows in 2009—or possible gains in years ahead. But make sure you don’t forget about your carry-forwards, or you could lose them forever. Losses in your name alone are not passed along to your heirs.

Monitor anticipated mutual fund distributions. Each year, mutual funds must distribute to their shareholders any earnings they might have realized from interest, dividends, and capital gains. So immediately after the distribution, the share price drops, and you’re likely to owe tax on the distribution if you own the fund in a taxable account.

There are a couple of options to consider when facing the potential tax liability on distributions. The primary distribution management strategy would be to avoid purchasing securities just prior to the distribution. Another would be to sell your shares just before the distribution date. The downside is that depending how much you paid for your shares originally, you could generate a significant capital gain—and a tax liability to go with it. Also, worthy replacement funds might be making distributions, too, and if your original fund is highly rated with good prospects, you might want to keep it.

Despite the complexity, taking all these factors into consideration and paying close attention to your funds’ anticipated distribution schedule can be an important tax-efficient strategy.