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Posted: February 28, 2013

Minimize taxes, maximize returns

You can do it without changing your portfolio

Wayne Farlow

Did you know that you can increase your investment returns without changing your current investment portfolio?  Many investors have taxable investment accounts, tax-deferred retirement accounts and even tax-free (Roth) accounts.  To increase investment returns, use the tax code to determine which investment assets to hold in each type of investment account.  This approach will maximize after-tax investment returns by minimizing investment taxes.

Tax-efficient investments should be held in taxable accounts.  Qualified dividends and long term capital gains and are very tax-efficient.  Most stock dividends are considered “qualified”, if the stock is held for more than 60 days. Stocks held for over one year are considered “long term.” Indexed stock funds, including Exchange Traded Funds (ETFs), are also tax efficient, if held for over one year.

Unless you are in the top tax bracket ($400,000 for individuals and $450,000 for couples), “qualified” stock dividends and long term capital gains are taxed at a maximum rate of 15 percent.  If you file jointly, with taxable income below $70,700 (2012), qualified dividends and long-term capital gains are not taxed at all.

Actively managed funds must be further researched before determining their tax efficiency.  Mutual funds are required to distribute all realized capital gains and dividends annually.  With mutual funds, income taxes must be paid each year on all realized capital gains and dividends.  High turnover funds will likely have significant short term capital gains, taxed at ordinary income rates. If a mutual fund has a turnover rate above 50 percent, it is likely not tax-efficient.

Indexed ETFs and mutual funds generally avoid year-end taxable distributions and are typically tax efficient when held for at least one year.  Low turnover rate, actively managed mutual funds are also typically tax-efficient, when held for over one year.

Whenever possible, place tax-inefficient investments in your tax-deferred or tax free (Roth) retirement accounts.  Tax-inefficient investments are investments in which most, if not all of the income is taxed at ordinary income tax rates.  Interest payments on bonds and bond funds, as well as "nonqualified" dividends (such as those distributed by most alternative investments) are taxed at ordinary income tax rates.

Investments that generate short term capital gains are also tax-inefficient, since short term capital gains are taxed at ordinary income rates.  If you trade stocks or invest in high turnover rate, actively managed mutual funds, these investments should be held in your tax deferred or tax free accounts.

Real Estate Investment Trusts (REITs) or REIT mutual funds pay nonqualified dividends.  Bonds and bond based mutual funds pay taxable interest income.  Since interest income and non qualified dividends are taxed at ordinary income rates, these tax-inefficient investments should be held in tax deferred or tax free accounts.

ETFs make owning gold or silver as simple as buying a stock. However, with precious metal ETFs such as GLD (SPDR Gold Shares) or SLV (iShares Silver Trust), the shareholder is treated as if they own the actual gold or silver that backs the ETF.  The IRS considers precious metals to be collectibles.  Collectibles have a long-term capital gain tax rate of either 25 percent or 28 percent, depending upon the taxpayer’s marginal income tax rate.  Precious metal ETFs are tax-inefficient investments and should be held in tax-deferred or tax-free accounts.

Commodity ETFs such as DBC (PowerShares DB Commodity Index) often invest in futures contracts.  At the end of each year, the capital gains from a fund’s futures contracts holdings are taxed at 60 percent long-term rates and 40 percent at short term rates.  This income is reported on the annual K-1 form.  When possible, minimize both your taxes and tax reporting hassles by holding these investments in tax-deferred accounts.

Step 3 of our Seven Steps toward Financial Abundance is “minimize your taxes.”  By paying close attention to the types of accounts in which your investments are held, taxes are minimized which maximizes investment returns.  If you use a financial advisor for your investments, be sure that they are providing a tax-efficient investment approach.  The tax savings alone may pay your advisor’s asset management fees.

Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor firm.  He is a Certified Financial Planner (CFP®), focusing on Retirement Planning, Investment Management, Small Business Owner Planning and Sudden Wealth/Inheritance Planning.  His book, “Financial Abundance Guide,” is available free at www.farlowfinancial.com .  He can be reached at wayne@farlowfinancial.com or at 303-554-0309.

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