No one likes to pay taxes. But for some investors they want to do all they can to reduce their income tax burden. It has often been stated there are only two things certain in life: death and taxes.
Investors are subjected to two forms of taxes. They pay taxes for bond dividend income received at the ordinary tax rate. In addition, if they have a gain in a security and capture that gain by selling it within a year, the gain is subjected to the ordinary tax rate. However, if investors have held a security for more than one year and have a gain upon the sale, they would get a reduced tax rate which is known as the long-term capital gains rate.
Are there ways to reduce the tax burden for investors? There are. First as you can tell from the preferential tax treatment for investors holding securities more than one year, it’s best to invest for the long term.
We are a major proponent of asset class investing where you invest in large classes of similar stocks such as large U.S. companies or small international developed market companies in Europe and Asia. When you invest this way, it avoids the necessity of trading in and out of securities capturing the potential gains on a regular basis. The only time that you would need to sell the large asset class is to ensure that your overall portfolio allocation stays near the target allocation.
But are there other ways to reduce the tax burden? There are. While we still use asset class mutual funds in order to further potentially reduce the tax burden, we can use what is known as tax managed investing. The primary goal of any tax managed fund is to try to minimize its tax impact on investors.
The managers of these funds minimize the tax impact by laying additional considerations of the investment process such as seeking to avoid short-term gains, managing dividend payments and harvesting losses throughout the year. All of these techniques can be very important for investors in the highest tax bracket.
Avoiding short-term gains to get the favorable long-term capital gains treatment currently in place by the IRS. This could be done by technical tax lot accounting where they would sell the highest cost lots of stocks first to delay the capturing of that gain.
The tax managed funds that we use also reduce transaction costs by using a patient trading process. They use quantitative models to evaluate the trade-off between the transaction cost of actually executing the trade and the tax lost harvesting.
For the fixed income (bond) allocation, investors can use municipal bonds which avoids paying Federal income taxes on the bond income (under current tax law) and also eliminate the need to pay tax on the income from the investors home state (in most states).
All of these strategic moves have the goal of trying to lower the taxable income to the investor. What we like about using the tax managed funds for investors who are sensitive to reducing the potential tax bill is their ability to adapt to the ever-changing IRS tax code. The fund would be able to make changes to their operating procedures to reflect the most beneficial strategies through time. For some investors, paying fewer taxes is a substantial benefit in and of itself.
As you are preparing to file your taxes, pay attention to the amount of long term gains that you were able to achieve last year in your taxable portfolio versus short term gains. It will help you begin to understand how your portfolio is being managed.
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