The Invisible Tax Hit

By on December 8, 2014
Categories: TAXES

When you check your mutual fund investment returns, do you believe their performance figures?

If the fund says it rose 10% for the year, for instance, do you automatically assume that your portfolio enjoyed the same boost? Actually, you shouldn’t.

Many times the figures won’t match because of taxes. With the exception of retirement accounts, your actual returns will usually be lower due to the tax drag.

Taxes shrink investment accounts by an average of two percentage points a year, according to a widely cited study conducted by Lipper, a global leader in mutual fund data.

The Invisible Tax Hit

Two percentage points might not seem like a lot, but over your investing lifetime this loss can seriously erode a portfolio. Here’s an example of what can happen to a $100,000 portfolio with a seven-percent annual return that gets hit with an yearly two-percent tax bite over 30 years. By the end of three decades, the portfolio would be worth $450,000, which sounds great until you learn what the investments would have been worth without the tax hemorrhage. Sheltered from taxes, the portfolio would have exceeded $750,000.

While it’s not possible to avoid all investment-related taxes, you can definitely minimize what you owe to the IRS by practicing tax-efficient investing. Here are three strategies to minimize your investing taxes:

Pay attention to asset allocation.

Some investments are natural tax hogs so you ideally want to keep them corralled in accounts where they won’t cause trouble. Retirement accounts are an ideal location for tax-inefficient investments because they are sheltered from taxes as long as the money remains tucked inside the account. Investments that generate high interest income, lots of dividends and high turnovers are good candidates for retirement accounts. Investments that fit this description include taxable bond funds, high-yield dividend stocks and real estate investment trusts (REITs).

The best prospects for taxable accounts would be inherently tax friendly and would include long-term stock holdings, municipal bonds and tax-efficient mutual funds.

Don’t be antsy.

Investors tend to get into trouble when they jump in and out of investments. Doing so can generate short-term capital gains, which triggers a tax that is much stiffer than the tax assessed for profits generated for investments that you’ve held for more than a year.

A profit is treated as a short-term gain if you dump the investment within one year. These gains will be taxed at your ordinary income tax rate. In contrast, long-term capital gains are taxed at 0%, 15% or 20%, depending on a person’s marginal tax bracket.

Harvest your losses.

You can cut your tax bill if you decide to sell a losing investment because you will pocket a capital loss. This loss can offset income that your overall portfolio has generated.  You can use the capital loss to neutralize capital gains and up to $3,000 in ordinary income. If you can’t take advantage of the entire loss in one year, you can carry it forward to future years.

Learn More…

 8 Year-End Tax Tips

How Long Should You Keep Your Tax Records?

Lower Your Investment Costs, Increase Your Returns


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