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O Bee Blog

Strategies for Tax-Efficient Investing

By Dave Littleton, LPL Financial Advisor

As tax season officially ended on April 18th this year, we became sharply aware of the taxes we owe, and a reminder of the taxes we would rather avoid! That said, there are a few strategies one may employ that could assist with tax planning next year.
 
As just about every investor knows, it's not what your investments earn, but what they earn after taxes that counts. After factoring in federal income and capital gains taxes, the alternative minimum tax, and any applicable state and local taxes, your investments' returns in any given year may be reduced by 40% or more.
 
For example, if you earned an average 8% rate of return annually on an investment taxed at 28%, your after-tax rate of return would be 5.76%. A $50,000 investment earning 8% annually would be worth $107,946 after 10 years; at 5.76%, it would be worth only $87,536. Reducing your tax liability is key to building the value of your assets, especially if you are in one of the higher income tax brackets. Here are five ways to potentially help lower your tax bill.1
 
Invest in Tax-Deferred and Tax-Free Accounts
Tax-deferred accounts include company-sponsored retirement savings accounts such as traditional 401(k) and 403(b) plans, traditional individual retirement accounts (IRAs), and annuities. Contributions to these accounts may be made on a pretax basis (i.e., the contributions may be tax deductible) or on an after-tax basis (i.e., the contributions are not tax deductible). More important, investment earnings compound tax deferred until withdrawal, typically in retirement, when you may be in a lower tax bracket. Contributions to nonqualified annuities, Roth IRAs, and Roth-style employer-sponsored savings plans are not tax deductible. Earnings that accumulate in Roth accounts can be withdrawn tax free if you have held the account for at least five years and meet the requirements for a qualified distribution.
 
Look for Tax-Efficient Investments
Tax-managed or tax-efficient investment accounts and mutual funds are managed in ways that may help reduce their taxable distributions. Investment managers may employ a combination of tactics, such as minimizing portfolio turnover, investing in stocks that do not pay dividends, and selectively selling stocks that have become less attractive at a loss to counterbalance taxable gains elsewhere in the portfolio. In years when returns on the broader market are flat or negative, investors tend to become more aware of capital gains generated by portfolio turnover, since the resulting tax liability can offset any gain or exacerbate a negative return on the investment.
 
Pitfalls to avoid: Taxes are an important consideration in selecting investments but should not be the primary concern. A portfolio manager must balance the tax consequences of selling a position that will generate a capital gain versus the relative market opportunity lost by holding a less-than-attractive investment. Some mutual funds that have low turnover also inherently carry an above-average level of undistributed capital gains. When you buy these shares, you effectively buy this undistributed tax liability.
 
Put Losses to Work
At times, you may be able to use losses in your investment portfolio to help offset realized gains. It's a good idea to evaluate your holdings periodically to assess whether an investment still offers the long-term potential you anticipated when you purchased it. Your realized capital losses in a given tax year must first be used to offset realized capital gains. If you have "leftover" capital losses, you can offset up to $3,000 against ordinary income. Any remainder can be carried forward to offset gains or income in future years, subject to certain limitations.
Pitfalls to avoid: A few down periods don't necessarily mean you should sell simply to realize a loss. Stocks in particular are long-term investments subject to ups and downs. However, if your outlook on an investment has changed, you may be able to use a loss to your advantage.
 
Keep Good Records
Keep records of purchases, sales, distributions, and dividend reinvestments so that you can properly calculate the basis of shares you own and choose the shares you sell in order to minimize your taxable gain or maximize your deductible loss.
 
Pitfalls to avoid: If you overlook mutual fund dividends and capital gains distributions that you have reinvested, you may accidentally pay the tax twice -- once on the distribution and again on any capital gains (or underreported loss) -- when you eventually sell the shares.
Keeping an eye on how taxes can affect your investments is one of the easiest ways you can enhance your returns over time. For more information about the tax aspects of investing, consult a qualified tax advisor.
 
If you need further assistance, please contact David Littleton, LPL financial advisor and O Bee Financial Services, at 360-570-7538, for any questions you may have.

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Source/Disclaimer:
1Example does not include taxes or fees. This information is general in nature and is not meant as tax advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.
Required Attribution: Because of the possibility of human or mechanical error by DST Systems, Inc. or its sources, neither DST Systems, Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall DST Systems, Inc. be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.
© 2017 DST Systems, Inc. Reproduction in whole or in part prohibited, except by permission. All rights reserved. Not responsible for any errors or omissions.
 


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