When investing, think about taxes
By Scott D. Nelson Special to the Acorn

While investment decisions shouldn't be based entirely on tax considerations, taxefficient investing may make a significant difference in net gain. Employing some of the following strategies could help retain more of potential investment earnings and lessen tax obligation.

Long-term stock investments

Following a buyandhold strategy for stock investments may save on taxes in the long run, as well as potentially increasing net worth. Trading stock holdings often, even once a year, may result in owing estimated taxes and a significant capital gains tax on profits.

Capital gains are taxed at 15 percent on investments held longer than one year. Gains on investments owned one year or less are taxed at the regular federal income tax rate, which is likely higher.

Tax-exempt investments

Taxexempt investments produce income that is generally exempt from federal and often state and local income tax. Municipal bonds may be a good choice, especially for investors in higher tax brackets. Income from municipal bonds may be subject to the alternative minimum tax.

To determine if a taxable or a tax-exempt investment is a better choice, calculate what a taxable investment would yield on an aftertax basis and compare that with the return on a tax-exempt investment. To do this, subtract the marginal tax rate from 100 percent and multiply this percentage by the rate of return the taxable investment is earning. That gives the aftertax yield. Compare this with the yield on the taxexempt investment to find out which is higher.

For example, in the 30 percent marginal tax bracket, a taxable investment return of 6 percent equates to an after-tax return of 4.2 percent (100 - 30 = 70; and 70 6 = 4.2).

Thus, a tax-exempt investment yielding higher than 4.2 percent will give a better yield after taxes are considered.

Offsetting capital gains

Capital losses offset capital gains dollar for dollar up to $3,000 of ordinary income a year. If there are capital gains to report on the income tax return, consider selling a losing investment and applying the loss to offset an equivalent capital gain.

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 investors 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, even if no distribution occurs or if 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.

Tax-deferred retirement

Participating in an employer's 401(k) or 403(b) plan (or a Keogh plan, if self-employed) reduces tax obligation, since taxes on contributions and earnings generally are deferred until the funds are withdrawn, 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 percent penalty.

Individual

retirement accounts

IRAs are another option to consider. 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 taxfree, provided certain conditions are met.

Hanging onto as much of your hard-earned money as possible is the goal of taxadvantaged investing. Your financial adviser can help you invest with this goal in mind.

Scott D. Nelson is an adviser with Sagemark Consulting/Lincoln Financial Advisors in Westlake Village. Call (818) 540 6952.