Your Portfolio: Choosing tax efficient investments

Managing your portfolio wisely can help control your tax bill. As always, you should consider many different factors when choosing investments, but for some individuals, tax cost may be one of the more influential factors in selecting their investments. Let’s look at some points to consider when evaluating the tax efficiency of different investments.

Bonds. There are two main types of bonds: tax-exempt and taxable. Municipal bonds, which are issued by state and local governments, pay interest that is usually exempt from federal income taxes. However, income from certain types of municipal bonds may be taxable for taxpayers subject to the alternative minimum tax.

Taxable bonds are typically issued by the U. S. government or a corporation and they are generally federally-taxed, but certain government bonds may be tax-exempt at the state level, subject to state law.

When evaluating which bond is most appropriate, one factor to consider is its yield. First, you need to calculate the taxable-equivalent yield for the municipal bond. Taxable-equivalent yield is the yield that a taxable bond would have to provide to match the yield on a bond whose interest income is exempt from federal (and possibly state) income taxes. For example, assuming you are in the 25 percent federal income tax bracket, a corporate bond would have to provide a 5.3 percent yield (excluding state tax) to match a four percent yield on a municipal bond. A decision between these two bonds would be tax neutral at these rates.

Keep in mind that if bonds are sold before their maturity, their yields and market values will fluctuate and they may be worth more or less than their original cost.

Stocks. If your goal is tax efficiency, you may want to choose a stock that pays little or no dividend in order to reduce your current taxable income. Investors who don’t need the dividend income usually hold these stocks for their growth potential. The stock grows tax-deferred until sold. By determining when you sell your stock, you are able to manage your gains and losses. Also, if you hold the stock for more than one year, it will be eligible for the long-term capital gains rate (currently a maximum of 15 percent), which is lower than the ordinary income tax rates applied to stock held one year or less.

If you need an income-producing stock, you can choose one that will pay dividends that qualify for the reduced dividend tax rate (as compared to your ordinary income tax rate). These qualified dividends are currently taxed at long-term capital gains rates.

It’s important to remember that the return and principal value of your stock, upon redemption, may be more or less than the original investment, based on changing market conditions.

Mutual funds. You may be able to reduce your taxes by choosing funds with minimal yields and low turnover. The yield will provide an indication of the amount of interest and dividends distributed by the fund. The turnover ratio measures the fund’s trading activity. Funds with higher turnover ratios typically distribute more capital gains, which are taxable to the investor. Investing in mutual funds involves risk and you should be aware that your principal and investment return in a mutual fund will fluctuate in value, and may be worth more or less than its cost, when redeemed.

Just because an investment offers tax advantages doesn’t necessarily mean it’s appropriate for your portfolio so before making any decisions, you should consider your goals regarding your return on investment, your time horizon and your risk tolerance. Your financial consultant can also help you decide what investments best fit into your overall portfolio.


This article was provided by Chris Facka, Financial Consultant and Certified Financial Planner of A.G. Edwards & Sons, Inc., Member SIPC. Chris may be reached at 239-642-6000.

© 2008 All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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