How investors can ease the growing tax bite

By Mark Jewell
Sunday, February 14, 2010

BOSTON -- If you're just beginning to think about this year's tax return, it might seem premature to consider tweaking your investment strategy for your next dance with Uncle Sam in 2011, and beyond.

Still polishing up your moves now might pay off. Mutual fund investors could see taxes take an increasingly bigger bite from their returns unless they know how to protect their portfolios.

It's clear where taxes are headed, now that the federal government is trying to get its fiscal house in order after spending heavily to rescue the financial system and get the economy going again.

"Taxes are going to have to go up," says Christopher Davis, a Morningstar fund analyst. "There's no way that you could even come close to balancing the budget or bringing the deficit down to normal levels by just cutting spending." Fund investors -- especially wealthy ones -- will want to watch how Congress responds to a proposal in President Obama's newly released budget. Next year, he wants to raise the capital gains tax rate from 15 to 20 percent for families making more than $250,000 a year, and individuals making more than $200,000.

If that's you, and Congress goes along with the change, shave 5 percent off any profit you see from selling investments held outside a tax-deferred account, such as a 401(k). Capital gains are triggered when you lock in profits by selling for more than your purchase price.

Even if you're not well-off, expect more of your income to be diverted in coming years as federal, state and local governments raise taxes and fees to repair recession-damaged budgets.

For investors, now is a good time to take a fresh look at tax strategies. Here are four considerations:

Decide what type of account is best: You can go a long way toward reducing a potential tax bill if you know where to hold specific investments. Rules vary, but in tax-deferred retirement accounts, earnings on your investments grow tax-free. Only withdrawals from the account are taxed. The appreciation on stocks and most bonds is taxable, so in most cases they're best kept shielded in accounts like IRAs or 401(k)s.

With a taxable retirement account, you'll pay taxes on sales, dividends and capital-gains distributions each year. So that's the ideal place to keep nontaxable investments, like municipal bonds.

Consider munis: Investors don't have to pay federal taxes on dividends from muni bond funds, which invest in local and state government bonds. Muni funds are also free of state taxes if they limit investments to the state where you live. So while muni returns are typically modest, your after-tax returns can look pretty good compared with taxable funds investing in stocks and corporate bonds.

Their draw is particularly strong if you're in a high tax bracket. So consider whether munis' tax-protected status will offset the higher pretax returns you'd normally expect from investing in a taxable bond fund. You want to look at tax-equivalent yield. It tells you how big of a return you'd need from a taxable investment to equal the return of a tax-free bond.

The formula is: The tax-equivalent yield equals the tax-free interest rate divided by (1 minus the tax rate). So an investor in the 33 percent tax bracket would need an investment yielding 7.4 percent to match a 5 percent tax-free return.

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