What Is Tax-Efficient Investing?

Have you ever gone to visit your CPA at tax time and found out, at the very last minute that you’ve got a huge tax bill due to gains in your portfolio?  The most likely cause is that your financial advisor didn’t take into account the tax consequences of their portfolio moves, generating a large taxable gain.

The are two ways to combat this problem:  regular tax planning and tax-efficient investing.  Tax planning should be an ongoing conversation with your CPA to avoid having any nasty surprises come tax time.

Tax-efficient investing involves handling your investments to maximize the AFTER-TAX return.  It’s not how much you made, but how much you kept after taxes.  The following are some ways to reduce the tax burden on your accounts:

Hold Onto Your Investments

When you hold an investment less than a year, any gain is taxed just like your regular income.  By holding the investment for at least a year before selling, you reduce the tax rate to (currently ) 15%.  Timing the sale of specific investments to lower that tax rate is critical.

“Harvest” Your Losses

In the second half of the year, as you re-balance your portfolio, you should look to sell positions that have lost money so that loss can offset gains you may have elsewhere.  The idea is “harvest” losses equal to your gains in order to eliminate the taxes due.

Put The Right Investments In The Right Accounts

Use tax-efficient investments, like Exchange Traded Funds (ETF’s) in your taxable accounts and put the higher-tax investments in retirement accounts like IRA’s and 401(k)’s.  The overall effect is that you have, hopefully, reduced your overall tax burden.

On a final note, let me remind you that this blog entry is merely to illustrate the concept of tax-efficient investing and should not be construed to be giving tax advice.  Before undertaking any investment program, consult your wealth manager and CPA as each circumstance is unique.


Dow Reaches Bear Territory

With it’s close today at at 11,344.33, the Dow Jones Industrial Average is now officially off 20% from its peak on October 9, 2007.  At a 20% loss, that means that this is now a bear market.

A wise man once told me that bear markets are always preceded by and followed by gains.  Bear markets are never fun since I don’t know too many people who like to lose money.  The problem right now is that our last bear market of 2000 – 2003, one of the longer ones on record by the way, is still fresh in people’s minds and that, coupled with the rising cost of gasoline and food, is causing more anxiety than the average bear market.

What’s a poor, frightened investor supposed to do?  Well, a number of things come to mind:

  1. Review your asset allocation to make sure it’s still in line with your goals.  If not, you may be able to re-allocate it with less of a tax consequence by ‘harvesting’ your losses to offset gains.
  2. Consider alternative investments that have little or no correlation to the overall market.  Have you noticed recently that, each time oil rises, the market falls?  By having a portion (and let me emphasize this again – A PORTION) of your portfolio dedicated to commodities, foreign exchange, real estate and other ‘alternative investments’ you can insulate your portfolio, reduce its volatility and even improve your portfolio’s performance over the long run.
  3. Look for buying opportunities.  If you liked a stock or mutual fund 7 months ago and you still think you want to own it, it’s currently on sale so you may want to buy now.
  4. DON’T PANIC.  Bear markets do end and you want to make sure that you don’t panic, bail out at the bottom, just to watch the market turn around a short time later.

The current stock market conditions are not much fun for anybody.  The important thing is to keep focused, don’t panic and be ready to pounce on opportunities that may arise.