Tax season is here again. The tax filing deadline for 2011 is April 18. The IRS is giving taxpayers an extra three days to file their taxes because Washington, D.C., is celebrating a public holiday on the usual filing deadline of April 15. Don’t you feel lucky?
In the spirit of tax season, here are five investment tax tips that will save you time and money.
1. Make Investing Your Priority: Taxes should always be a secondary consideration in your investment decisions. Making an investment decision solely for tax purposes is a mistake. If you don’t like the future prospects of a stock or fund you own, don’t keep it just because you’ll pay capital gains taxes if you sell. If your assessment of the security’s future prospects is correct, paying 15% in capital gains taxes could be better than standing by while the security’s value falls precipitously.
2. Location, Location, Location: Proper asset location can boost your after-tax returns. When possible, put your least tax-efficient investments in tax-deferred or exempt accounts and your most tax-efficient investments in taxable accounts. That generally means that taxable bonds, precious metals, currencies, and real estate investment trusts should be favored in tax-deferred or exempt accounts, and domestic and international equities as well as tax-exempt municipal bonds should be favored in taxable accounts.
3. Harvest Losses: Harvest capital losses when possible, and use them to offset future capital gains. The proliferation of exchange-traded funds (ETFs) has made the chore of tax-loss harvesting much easier. By example, if you own an actively managed sector fund that is trading at a meaningful loss, you can sell it, recognize the loss, and immediately purchase an ETF in the same sector. There is no waiting 30 days to comply with the wash-sale rules. You are buying a substantially different security in the eyes of the IRS, but you maintain the sector exposure you want. The loss you realize on the security can be used to offset future capital gains.
4. Don’t Buy Capital Gains Distributions: This is a tip to remember at year-end when most mutual fund companies declare their annual capital gains distributions. To avoid paying taxes, mutual funds are required to distribute all of their realized capital gains (and dividends) to shareholders on an annual basis. It is important not to buy a mutual fund shortly before it makes its annual capital gains distribution. Why? Assume that a $10 mutual fund declares a $1 capital gains distribution with a record and pay date of December 7. If you buy one share of that fund on December 6 for $10, the following day you will receive a $1 capital gains distribution. The fund’s net asset value or price will drop to $9. You now have $9 in the fund and $1 in cash for a total of $10. So what’s the problem? Assuming the long-term capital gains rate, you now owe the IRS $0.15 on the $1 capital gains distribution you received. Even without assuming any market fluctuation, you are down 2.50% on your $10 investment. If you instead waited until December 8 to buy the fund, you would owe no taxes.
5. Bring in the Professionals: If you are like many investors, preparing your taxes on a sunny April weekend is the last thing you want to do. The tax code is over 70,000 pages long, and the rules change annually. If your tax situation is the least bit complicated, I see no reason to go it alone. Hire a tax-professional. The modest investment is well worth it to avoid the time and frustration of attempting to navigate the U.S. tax code on your own. Plus, a tax professional is likely to know about all of the deductions and exemptions that could save you thousands.
Jeremy Jones, CFA
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