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Risk, return, rewards. You consider many factors when deciding where and how to invest your money. What about taxes? Too often, a large portion of an investment's return finds its way into the taxman's pocket rather than yours. Investing with an eye towards tax efficiency is one way to keep more of the wealth you've gained for yourself.
Some mutual funds - tax-efficient funds - exist primarily to reduce the tax burden on returns by avoiding distributions. For example, they may not sell high-flying stocks, or they may balance gains and losses in an effort to negate the effects of capital gains. These funds are gaining in popularity, as investors become savvier about recognizing taxes as an important factor in assessing a fund's return, and the fund companies have responded.
How can you put these tax-saving investments to work for you? First, be sure to use these funds in a taxable account, rather than a tax-deferred IRA. Next, you must decide whether to invest in mutual funds or in individually held stocks. Tax-efficient investing can be achieved with both and, as with all investments, there are pros and cons to consider. A potential downside of mutual fund investing is that regardless of when you purchased the shares, you may get hit with a large year-end tax bill on capital gains, even if you only owned the fund for a few weeks. Holding individual stocks avoids this pitfall, since the investor has control over when to take gains. Following are some guidelines to consider when deciding whether mutual funds or individual equities are more appropriate for your tax-efficient investment strategy.
Some investors find these choices overwhelming at worst and confusing at best. A simpler road to follow may be "passive investing," which is investing only in funds pegged to indexes. This strategy takes the guesswork out of when to trade in order to minimize your tax exposure. However, a main drawback to passive investing is that it fails to take advantage of market inefficiencies. Given the cyclical nature of the market, there are times when opportunities present themselves-good times to buy or sell-upon which passive investing cannot capitalize. Actively managed funds, however, can take advantage of these market opportunities, overweighting sectors that are on the rise, or aggressively buying individual stocks. The nature of index funds necessitates that they will never perform better than the market; they will always under-perform by the amount of their costs. Thus, while passive investing is one way to invest with taxes in mind, it may not be the best way to minimize tax consequences while still earning a profit. Actively managed funds that utilize a disciplined investment process that keeps tax consequences in mind will usually win out over the long haul.
There are other investments to consider in addition to mutual funds and individually owned equities when planning a tax-efficient strategy. For example, variable annuities are only taxed upon withdrawal as ordinary income. Generally, the ordinary income tax rate is higher for most people than the capital gains rate, so these investments may not always be the wisest choice from a tax perspective. If your income is high, you may wish to favor municipal bonds over government and corporate offerings to buffer volatility.
Finally, don't let the tax tail wag the dog. While there are merits to tax-efficient investing, you should make your investment decisions based on the quality of the investment and not solely on its tax consequences. A sound investment strategy looks at the whole picture, and it may be wise to incorporate tax-efficient funds within a diversified portfolio to help you maximize your return and minimize Uncle Sam's.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.