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Roger E. Muns

Investors face a variety of expenses including trading costs (primarily, commissions and bid-ask spreads), custodial fees, management fees and/or others.

However, the biggest expense is income taxes on investment earnings!

For example, if bond taxable interest income totaled $25,000 during the year and your federal and state tax brackets total 35 percent, you would pay $8,750 of federal and state income taxes on that interest income.

Case Study: Dr. Brown is a talented, compassionate and dedicated doctor and a steady saver. Initially, he fully funded his 401(k) account each year. Later as his practice grew, annual contributions into his taxable investment account began to increase over time. By the time he reached 50, the values of Brown's 401(k) account and taxable account were significant. The values grew from his steady savings habit and because he was an intelligent investor.

Brown is in the high federal and state income tax brackets. Besides generating taxable income from his practice, earnings in his taxable investment account push taxes even higher!

How can Brown reduce taxable investment income and the related federal and state income taxes?

The primary way to reduce current taxable income is through proper asset allocation. Specifically, hold tax inefficient investments in the tax deferred 401(k) account and tax efficient investments in the taxable account.

Tax inefficient investments, if held in a taxable account, generate a lot of current taxable income. They include cash, CDs, corporate and United States government bonds, preferred stocks, high-yielding stocks and others.

Tax efficient investments generate less taxable income. These primarily include low dividend-yielding stocks and tax-efficient equity mutual funds.

The key is for Brown to view all financial assets in the 401(k) and taxable accounts as parts of his overall portfolio. Let's assume that the investment policy for his overall portfolio prescribes an asset allocation of 35 percent bonds and 65 percent stocks (domestic and foreign). His goal is to reduce the overall portfolio's current taxable income and defer the tax bite for many, many years. Deferring $8,750 of income taxes in a single year and earning 7 percent per annum for 20 years on that amount would accumulate to $33,860!

Bonds. If all bonds were held in the 401(k) account, he would probably hold investment-grade corporate or United States Treasury bonds. These bonds would be generating no current taxable income since they are in a tax-deferred account. If the same corporate or treasury bonds were held in the taxable account, he would have a big tax bite. On the other hand, he could hold only Mississippi municipal bonds in the taxable account. These bonds would generate no taxable income but regrettably earn about 30 percent less than corporate or United States Treasury bonds. Clearly, holding bonds (and cash and CDs) in a taxable account should be avoided.

High Dividend-Yielding Stocks. Real estate investment trusts are not taxed at the corporate level, so their ordinary dividends are taxed at ordinary (high) income tax rates. Other stocks yielding high dividends include utilities, many financial institution, preferred stocks and companies in mature industries. Clearly, holding these stocks in a taxable account should be avoided, too.

Low Dividend-Yielding Stocks. Today, the dividend yields on most stocks are under 2 percent, about 60 percent less than the current interest rates. In addition, for dividends paid on domestic and qualified foreign corporation stocks held more than 60 days prior to the ex-dividend date, the tax rate on these dividends are only 15 percent for most people.

Frequently, companies that pay low or no dividends seek to reinvest their income in new opportunities. If successful, the stock will appreciate and when sold could generate a long-term capital gain, which is taxed at a low 15 percent rate. If the stock depreciates, it could be sold at a capital loss that could lower Brown's taxable income by up to $3,000. And if the net capital loss is more than $3,000, he could carry the loss forward to later years. Realized capital losses in the 401(k) account do not lower current taxable income.

Tax efficient Mutual Funds. Most mutual fund managers focus only on maximizing total returns — disregarding the tax consequences of their trades. Some focus on maximizing after-tax total returns. Morningstar's database of mutual funds includes "tax cost ratio" data. It shows how much a fund's total return must be reduced for income taxes to arrive at after-tax returns. This is important data to consider when selecting a mutual fund for a taxable account.

Conclusion. By properly maintaining tax inefficient investments in 401(k) and other tax-deferred plans and maintaining efficient investments in taxable accounts, Brown will reduce his current income taxes, increase his accumulated investments and defer the tax bite for many, many years.

Next month: other tax-saving ideas.



Roger E. Muns, CFA and CPA, of Wealth Management, LLC, in Jackson, is president of Chartered Financial Analyst (CFA) Society of Mississippi.

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