HomePersonal FinanceTaxes

How to Make Your Savings Tax-Efficient

mainstreet

by Jeff Brown

Investors have two reasons for procrastinating on tax returns: doing them is such a big, miserable hassle, and the result can be a nasty tax bill.

The first problem is, well, a fact of life. But it�s possible to do something about the second, by improving �tax efficiency.� This is the time of year to think about that, as the recently arrived 1099 forms from your bank, brokers and mutual fund companies will help you uncover the inefficient aspects of your portfolio.

The 1099 forms show several types of taxable income: interest, dividends and capital gains, both long- and short-term.

To minimize the annual tax bills from these income sources, consider shifting to comparable holdings that don�t churn out as much annual income.

Many actively managed mutual funds pay large annual distributions from profits the fund earned by selling holdings during the year. Index-style funds, which use a buy-and-hold strategy, generally have smaller yearly distributions.

Also, there are a number of �tax-managed� funds designed to minimize annual taxes even if they are actively managed. Managers, for example, may take extra care to find money-losing investments to sell, offsetting gains on winners. Or they may postpone sales of winners until they can get the lower long-term capital gains rate for investments held longer than a year.

Why don�t all funds do that? Because many investors own funds in tax-favored accounts like IRAs and 401(k)s, where there are no annual taxes. Managers don�t want the trouble and expense of tax-reduction strategies if most of the fund�s investors don�t care about them, especially if those maneuvers can reduce returns.

That gets to the second tax-cutting strategy: putting the annual income producers into those tax-favored accounts. In addition to any funds that produce big distributions, this would include those that pay a lot of interest, such as bond funds. In taxable accounts, interest is taxed at income-tax rates as high as 35%. So, unless you need the interest income right away, put interest producers into an IRA or 401(k). That way you won�t pay tax until the money is withdrawn, though you�ll still pay at income-tax rates. Unless, of course, you use a Roth IRA, where withdrawals are tax-free.

If you do rely on interest earnings for ordinary living expenses and aren�t yet eligible for penalty-free withdrawals from an IRA or 401(k), you�ll have to put bonds or bond funds in a taxable account. In that case, consider investing in municipal bonds, whose interest earnings are tax-free.

What else goes into a taxable account? Ideally, investments whose returns come primarily from long-term capital gains, such as stocks or stock funds. These will be taxed at a maximum rate of 15%, and the tax won�t be due until you sell the investment. The same investment would be taxed at the potentially higher income tax rate if held in a traditional IRA or 401(k), since all withdrawals from those accounts are taxed as income.

Decisions are tricky when it comes to dividend-paying investments � stocks or stock funds. In some respects, they work best in taxable accounts, where dividends are taxed at no more than 15%. In an IRA or 401(k), dividends are taxed as income.

Unfortunately, dividends from a taxable account are taxed in the year they are received. Unless you need dividends to live on, you could postpone tax if the dividend payers were in a tax-favored account. Whether that would pay off mainly depends on the income tax bracket you expect to be in when you make withdrawals. If it will be high, such as 35%, dividend payers might be better in a taxable account, where you�d pay 15%, even though you�d have to pay the tax every year.

�For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.