Increase investment returns—guaranteed!

There is guaranteed way to increase investment returns without adding any investment risk or even changing your current investments. Most investors have taxable investment accounts as well as tax-deferred retirement accounts and even tax-free (Roth) accounts. To increase investment income, determine which investment assets should be held in which types of accounts. With this approach, you can maximize after-tax income by minimizing investment taxes.

Now that Congress has approved an extension of the investment income tax rates, it is important to examine investment holdings. If possible, have only tax efficient investments in taxable accounts. Let’s examine what types of investments are tax-efficient.

Through at least 2012, “qualified” stock dividends and long term capital gains are taxed at a maximum rate of 15 percent. Most stock’s dividends are “qualified”, as long as the stock is held for more than 60 days. Stocks held for at least one year and a day will have their appreciation (capital gains) taxed at the maximum rate of 15 percent, making them very tax efficient. Indexed stock funds, including most Exchange Traded Funds (ETFs), are also considered tax efficient, if held over one year. Unfortunately, actively managed mutual funds require some research before determining their tax efficiency.

Each year, mutual funds must distribute all realized capital gains and dividends. Mutual funds with high turnover rates will likely produce short term capital gains. Regardless of how long a mutual fund is held, income taxes must be paid each year on all realized capital gains and dividends. High turnover rate funds may have a significant amount of short term gains, taxed at ordinary income rates. This type of mutual fund is not tax-efficient.

Stock based ETFs generally avoid year end taxable distributions, as do many stock index based mutual funds. As long as the fund is held for over one year, actively managed mutual funds with low turnover rates and index based ETFs and mutual funds will typically be tax-efficient.

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 their income is taxed at ordinary income tax rates. Interest payments on bonds and bond funds, as well as “nonqualified” dividends are taxed at ordinary income 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 plan to trade stocks on a short term basis or wish to invest in high turnover rate mutual funds put these investments in your tax deferred account.

Real Estate Investment Trusts (REITs) or REIT funds pay nonqualified dividends. Bonds and bond based funds pay taxable interest income. Since these payments are taxed at ordinary income rates, these investments are considered “tax-inefficient” and should be kept in your tax deferred accounts, when possible

With ETFs, owning gold or silver is now as easy 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 therefore tax-inefficient investments to be kept 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 a tax-deferred account.

Step 3 of the Seven Steps toward Financial Abundance is “minimize your taxes.” By paying close attention to the types of accounts in which investments are held, you can minimize your taxes while maximizing your after-tax investment return.
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Wayne Farlow is the founder of Financial Abundance, LLC, a Registered Investment Advisor, providing fee-only financial planning, asset management and retirement planning services. He is the author of “Financial Abundance Guide,” available free at . He can be reached by email at or at 303-554-0309.




Categories: Finance