From the March 2012 issue of Investment Advisor • Subscribe!

How to Avoid Investors’ Most Taxing Problem

Here are a few strategies—some simple, some sophisticated—to ease your clients’ tax pains

You can have great returns on your investments, but if Uncle Sam is taking a lot of those gains through taxes, you ultimately end up with below-average returns.

The first step to prevent this is to invest in vehicles with very low portfolio turnover. Low portfolio turnover equals low capital gains. Some mutual funds invest specifically with this strategy in mind; however, exchange-traded funds (ETFs) based upon large indexes are ideally suited for this purpose.

The second step is to balance equity holdings with bond holdings. Municipal bonds offer tax-free income; however, in the event of a severe market downturn, these bonds provide little protection. It may be tempting to buy bonds that are free from state and local taxes, but it is important to focus on diversification to reduce risk. This means owning municipal offerings from states other than your primary residence, even if this results in some state income tax having to be paid.

If the goal of the bond portfolio is to provide protection along with tax-free income, it is important to maintain a position in high credit-quality bonds, including Treasuries. While Treasuries are not tax-free for federal purposes, they do have the advantage of being state income tax-free.

Another strategy is to utilize a loss harvesting strategy. With the tremendous number of ETFs available, this has become a very easy strategy to implement while maintaining a consistent asset allocation strategy and overall diversification. Let’s say an investor owns SPY, an ETF that mirrors the S&P 500 Index, and has a loss. This loss can be realized and the investor can turn around and invest the proceeds in OEF, the ETF that mirrors the S&P 100 Index. By doing this, the investor has not significantly changed his asset allocation or diversification.

A corollary to loss harvesting is tax lot accounting, which keeps track of the dates of purchases, sales and cost basis of various trades made in the same security. Suppose an investor made several purchases of ABC stock: 100 shares at $10 per share, 100 shares at $15 per share and a final purchase of 100 shares at $20 per share. The current price of the stock is $17 per share and the investor wants to liquidate 100 shares. He could designate the stock that he purchased at $20 per share, thereby incurring a $3 per share loss that he can use to offset other gains or ultimately to reduce his ordinary income tax.

Frequently, clients will have highly appreciated concentrated stock positions. From an allocation, diversification and risk standpoint, these can cause problems, but liquidating these positions can be particularly troublesome from a tax point of view as well. It’s normally advisable for individuals in this situation to establish a tax budget and plan to liquidate the shares gradually over several tax years.

Another strategy for highly appreciated stock is to use these positions for charitable gifting. Donating the stock to a charity provides the taxpayer with a deduction for the entire amount of the donated stock. The charity, on the other hand, can liquidate the stock and, because of its status as a charitable organization, pay nothing in taxes.

Another tax-efficient strategy is to look at the location of particular investments. For example, placing income vehicles such as taxable bonds and dividend-paying stocks in an IRA, where taxes are deferred, and growth stocks and municipal bonds in a retail account can be a very effective approach. The taxable investments grow tax deferred, so their tax status does not matter, allowing taxable investments to be invested in vehicles that produce very little income.

Equally as important as tax-efficient investing are tax-efficient distributions. Since distributions from IRAs are taxable as ordinary income, it’s important to understand the marginal tax brackets, as well as tax deductions. By monitoring this, it’s possible to take distributions from an IRA while keeping the marginal tax rate low and then taking additional distributions from taxable vehicles where capital gains rates apply.

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