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Strategy
Tax-Efficient Investing: A Wise Choice
By Luke LeMener, CFP, CLU
Private Wealth Advisor, Lincoln Financial Advisors Corporation
Taxes can take a chunk out of your investment returns; yet, many investors don’t give much thought to taxes when they make investment decisions. While investment decisions shouldn’t be based entirely on tax considerations, tax-efficient investing may make a significant difference in your net gain. Employing some of the following strategies could help you retain more of your potential investment earnings and lessen your tax obligation.
Invest in Stocks for the Long Term
Following a buy-and-hold strategy for your stock investments may save on taxes in the long run, as well as potentially increasing your net worth. If you trade your stock holdings frequently ? even if it’s only once a year ? you may end up owing estimated taxes and a significant capital gains tax on your profits.
Capital gains are taxed at 15% on investments you hold longer than one year (5% for gains that would otherwise be taxed in the 10% or 15% marginal federal income tax bracket). Gains on investments you’ve owned one year or less are taxed at your regular federal income-tax rate, which may be as high as 35% for 2005. So, even if you reinvest your sales profits, taxes will reduce the amount you’re reinvesting, effectively diminishing the size of your portfolio and its overall potential return.
Tax-exempt Investments
Tax-exempt investments, such as municipal bonds, produce income that is generally exempt from federal ? and often state and local ? income tax. If you’re seeking income rather than growth, municipal bonds may be a good choice. This is especially true for investors in higher tax brackets. Income from municipal bonds may be subject to the alternative minimum tax.
To determine whether you would be better off buying a taxable or a tax-exempt investment, you need to calculate what a taxable investment would yield on an after-tax basis and compare that with the return on a tax-exempt investment. To do this, subtract your marginal tax rate from 100% and multiply this percentage by the rate of return the taxable investment is earning. That will give you your after-tax yield. Compare this with the yield on the tax-exempt investment to find out which is higher.
For example, if you are in the 30% marginal tax bracket, a taxable investment return of 6% equates to an after-tax return of 4.2% (100% – 30% = 70%; 70% × 6% = 4.2%). Thus, a tax-exempt investment yielding higher than 4.2% will give you a better yield after taxes are considered.
Sell a Loser To Offset a Capital Gain
Capital losses offset capital gains dollar for dollar and up to $3,000 of ordinary income a year. If you will have capital gains to report on your income-tax return, consider selling a losing investment and applying the loss to offset an equivalent capital gain.
Mutual Funds with Low Turnover Rates
A mutual funds turnover rate measures the extent to which the fund sells securities and replaces them with new ones: the higher the turnover rate, the more frequently the fund’s managers are trading the fund’s holdings. Turnover rate is important to you as an investor because, when the fund sells securities, a capital gain or loss generally occurs for tax purposes. A portion of any capital gains realized by the fund is taxable to you, even if no distribution occurs or if your distribution is reinvested in additional fund shares. A low turnover rate indicates that capital gains generated by sales of appreciated securities should be kept to a minimum, allowing you to wait until you sell fund shares to take potential profits.
Mutual funds are offered by prospectus. An investor should carefully consider the investment objectives, risks, charges and expenses of an investment company before investing. To obtain a prospectus that contains this and other information call or ask your financial representative for a free prospectus. Read it carefully before you invest or send money. The investment return and principal value of an investment will fluctuate with changes in market conditions so that an investor’s shares, when redeemed may be worth more or less than the original amount invested.
Tax-deferred Retirement Plan
Don’t neglect your retirement plan as a vehicle for tax-deferred investing. Participating in an employer’s 401(k) or 403(b) plan (or a Keogh plan, if you’re self-employed) reduces your tax obligation, since taxes on your contributions and earnings generally are deferred until you withdraw funds from the plan, typically at retirement. Distributions may be subject to income taxes and if made prior to the age of 59 ½, are subject to an additional Federal 10% penalty.
Individual Retirement Accounts (IRAs) are another option to consider if you are eligible. Your contributions to a regular IRA may be tax deductible. And, although contributions to a Roth IRA are not deductible, account earnings are tax deferred and can ultimately be withdrawn from the Roth IRA income-tax free, provided certain conditions are met.
Hanging onto as much of your hard-earned money as possible is the goal of tax-advantaged investing. Your financial advisor can help you invest with this goal in mind.
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