Manage Your Portfolio, Help Control Your Tax Bill by Patricia Green
Keep tax costs top-of-mind
Investors need to consider many factors in the process of choosing investments. One at the top of the list is an investment’s tax cost. In fact, for some individuals, this issue may be among the more influential factors when selecting investments.
The following are some points to consider about the tax efficiency of different investments you may hold in taxable accounts.
Effective Jan. 1, 2013, Congress implemented a new Medicare surtax of 3.8% on net investment income. The tax will affect taxpayers with modified adjusted gross income in excess of $200,000 for single individuals and $250,000 for married couples. The appeal of some of these investments may change depending on whether you are subject to this additional tax.
The appeal of stocks, bonds, and mutual funds
Stocks. If your goal is tax efficiency, consider stocks geared more toward growth with a low dividend yield to reduce your current taxable income. The growth is tax-deferred until you sell the stock. This ability to defer tax provides some flexibility because you can manage your gains and losses based on when you sell your stock. If you hold the stock for more than one year, the gain will be eligible for a lower long-term capital gain rate as opposed to the ordinary income tax rate.
If you need an income-producing stock, consider one that will pay dividends that qualify for the reduced qualified-dividend rates versus ordinary income rates. The rate for qualified dividends is the applicable capital gains rate. Bear in mind, dividends are not guaranteed. A company may reduce or eliminate its dividend at any time.
Qualified dividends are paid by U.S. corporations and some foreign corporations. A qualified foreign corporation is one incorporated in a U.S. possession, eligible for tax-treaty benefits with the United States, or traded on an established United States securities market. Income from preferred instruments qualifies to the extent it represents an equity instrument rather than a debt instrument. Mutual fund dividends do not qualify unless the dividends passed through are from qualified corporations, as described above. It’s important to note that real estate investment trust (REIT) dividends do not qualify for the reduced rate.
Keep in mind, the return and principal value of an investment in stocks fluctuates with changes in market conditions. Upon redemption, it may be worth more or less than the original investment.
Mutual funds
You may be able to reduce your taxes by choosing funds historically managed with low turnover and minimal yields. The yield will provide an indication of the amount of interest and dividend distributions. The turnover ratio measures the fund’s trading activity. Funds with higher turnover ratios typically distribute more capital gains, which are taxable to the investor whether they are paid out or reinvested.
To help evaluate the effects of taxes on mutual fund returns, use Morningstar’s Tax Cost Ratio, which represents the percentage reduction in an annualized return resulting from income taxes. This can provide an estimate of how much of your investment return you would lose to taxes. This type of planning can provide some guidance on the taxability of the annual distribution.
However, the fund manager’s actions will ultimately determine the capital gains distributions for the year. This can have significant tax implications. Of course, as with any financial decisions, investment considerations should take priority over tax issues.
There are risks associated with investing in mutual funds. Your investment return and principal value will fluctuate, and you may receive more or less than your original investment when you redeem your shares.
Look at the whole picture
Though our focus here is on tax-efficient investing, remember: just because an investment offers tax advantages doesn’t mean it’s appropriate for your portfolio – look at the whole picture. However, it’s a factor to consider – especially if you’re in one of the higher tax brackets.
Before you invest, you need to consider your goals regarding return and risk as well as your time horizon. Only by taking all of these factors into consideration can you determine whether a particular investment is right for you.
This article was written by/for Wells Fargo Advisors and provided courtesy of Patricia B. Green, CFP®, Financial Advisor, Senior Vice President – Investments in Houston, TX at 713-403-7331.
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