Choosing Tax-Efficient Investments

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Manage Your Portfolio to Help You Control Your Tax Bill

When choosing investments, you may need to consider many factors, including taxes. In fact, for some individuals, their investment’s tax cost may be among the more influential factors.

Here are some things to consider about the tax efficiency of different investments you may hold in taxable accounts. Effective Jan.1, 2013, Congress implemented a new Medicare surtax of 3.8% on net investment income. The tax will affect taxpayers with modified adjusted gross income in excess of $200,000 for single individuals and $250,000 for married couples. The appeal of some of these investments may change depending on whether you are subject to this additional tax.

Mutual Funds

Mutual funds are tax-efficient if you choose funds that have historically been managed with low turnover and minimal yields. The yield provides an indication of the amount of interest and dividend distributions. 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 whether they are paid out or reinvested.

In the end, it’s the fund manager’s actions that will ultimately determine the capital gains distributions for the year, which can have significant tax implications. Of course, as with any financial decisions, investment considerations should take priority over tax issues.

There are risks associated with investing in mutual funds. Your investment return and principal value will fluctuate, and you may receive more or less than your original investment when you redeem your shares.

Municipal Bonds

Municipal bonds, which state and local governments issue, pay interest that’s exempt from federal income taxes – although some may be subject to the federal alternative minimum tax (AMT). The interest is also often exempt from state taxation if you purchase bonds issued by either the state where you live or a local government within the state. Although interest income is tax-free, capital gains, if any, are subject to taxes.

Before purchasing a municipal bond, you must consider whether the tax-free interest is beneficial enough to overcome the potential for the higher yield that a taxable government or corporate bond may provide. To compare a tax-free versus a taxable bond, consider the taxable-equivalent yield.

For example, a municipal bond with a 4% yield would be similar to a corporate bond with a 5.3% taxable yield (assuming you are in the 25% income tax bracket and excluding state tax). A decision between these two bonds might still favor the tax-free bond, because the taxable bond would add to your adjusted gross income (AGI), and the calculations related to AGI and AMT.

Investing in fixed income securities involves certain risks, such as market risk if sold before they mature and credit risk, especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income investments may be worth less than their original cost upon redemption or maturity. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment.

Stocks

If your goal is tax efficiency, consider stocks geared more toward growth with a low dividend yield to reduce your current taxable income. The growth is tax-deferred until you sell the stock, which gives you some flexibility, because you can manage your gains and losses based on when you sell your stock. Also, if you hold the stock for more than one year, the gain will be eligible for a lower long-term capital gains rate as opposed to the ordinary income tax rate.

If you need an income-producing stock, consider one that will pay dividends that qualify for the reduced qualified-dividend rates versus ordinary income rates. The rate for qualified dividends is the applicable capital gains rate. Keep in mind, dividends are not guaranteed. A company may reduce or eliminate its dividend at any time.

The return and principal value of an investment in stocks fluctuates with changes in market conditions. When sold, it may be worth more or less than what you originally invested.

Annuities

A deferred annuity in a taxable account (nonqualified annuity) lets you defer taxes on income earned until you take withdrawals, which typically occurs during retirement when it’s possible you’ll be in a lower tax bracket. When you take withdrawals, the earnings portion of the annuity is taxed as ordinary income rather than as a capital gain. If you take withdrawals from the annuity before age 59 1/2, the earnings portion of the withdrawal will be subject to a 10% IRS penalty (with a few exceptions).

Of course, the effects of these tax benefits may be offset somewhat by an annuity’s internal insurance and administration expenses. Annuities bear some risk associated with the issuer’s credit worthiness.

An annuity may offer the tax-planning benefits you are looking for, but keep this in mind: Annuities are intended to be long-term investments and may not be suitable for all investors. Your principal and investment return in a variable annuity will fluctuate in value. Your investment, when redeemed, may be worth more or less than the original cost.

Before you invest in an annuity, also consider:

  • Your age, tax bracket, and time horizon for the investment
  • The tax penalty for early withdrawal
  • The potential for surrender charges

Master Limited Partnerships

Master limited partnerships (MLPs) are publicly traded partnerships. They are usually slow-growth, high-cash-flow businesses.

One benefit to the investor is that MLPs generally distribute as much of their cash flow as possible on a regular basis. Another benefit is that most of the distribution is tax-deferred, although the amount of tax deferral will vary throughout the investment’s life, which means this type of investment may be attractive for retirees.

While MLPs offer unique tax benefits, their tax treatment is much more complex than that of most investments. During the year, the investor receives regular cash distributions that are treated as a tax-free return of capital. After year-end, the investor receives a Schedule K-1 showing the taxable amount of net income from the MLP operations. The difference between the cash distribution and the K-1 net income is considered the tax-deferred portion of the distribution. The cumulative tax-deferred portion of the distribution must be recaptured and taxed as ordinary income in the year the units are sold if there is a gain on the sale.

Because of the complexity of tax reporting for this investment, you should talk with your tax advisor before investing in an MLP.

In some cases, the net income from operations for the year may actually be a loss. These passive losses are not deductible in the current year. The deferred losses may be used in future years, but only against net income earned by the MLP that generated the original losses. Any remaining losses become fully deductible when the asset is sold.

Risk factors that could lead to MLP investments underperforming the overall stock market include:

  • Rising interest rates
  • Inability to access external capital to fund growth
  • An adverse regulatory environment
  • Terrorist attacks on energy infrastructure
  • An overall economic downturn

These investments are not suitable for all investors.

Master Limited Partnerships (MLPs) are not appropriate for all investors and, particularly, are not usually appropriate for retirement-related accounts. Also, an MLP shareholder (i.e., a limited partner unit holder) receives a K-1 instead of a 1099. Investors should contact their tax accountant for further tax implications before investing in MLPs. Wells Fargo Advisors is not a legal or tax advisor.

Exchange-Traded Funds

Exchange-traded funds (ETFs) are mainly passively managed portfolios designed to track the performance of a certain index or basket of stocks. They trade on a stock exchange like a stock but share many attributes with mutual funds. With the expansion of the ETF market, some issuers have now introduced actively managed ETFs, which may be less tax-efficient than passively managed ones.

ETFs are generally tax-efficient investments. Because they typically have low turnover, they generally produce little or no capital gains; capital gains are usually realized only when a change in the underlying index is made. In addition, ETFs may be well suited for long-term, diversified equity exposure. However, you also need to consider that because ETFs share an underlying basket of stocks, similar to mutual funds, the dividends they pay may not qualify for the reduced tax rate. The tax treatment will depend on the nature of the underlying stocks that paid the dividends.

There are risks associated with investing in ETFs. Your investment return and principal value will fluctuate, and you may receive more or less than you originally invested when you sell your shares.

Look at the Whole Picture Before You Invest

Though our focus here is on tax-efficient investing, remember that just because an investment offers tax advantages doesn’t necessarily mean it’s appropriate for your portfolio. That’s something to think about, especially if you’re in one of the higher tax brackets. Before you invest, you need to consider your goals regarding return and risk as well as your time horizon. It’s only by taking all of these factors into consideration that you can determine whether a particular investment is right for you.

For More Information About Tax-Efficient Investments

Contact your Financial Advisor to learn more about these tax-efficient investments. He or she can work with you and your tax advisor to determine which investments make the most sense for you.

Wells Fargo Advisors does not provide legal, accounting, or tax-preparation services. If tax or legal advice is required, the services of a competent professional should be sought. Wells Fargo Advisors’ view is that investment decisions should be based on investment merit, not solely on tax considerations. However, the effects of taxes are a critical factor in achieving a desired after-tax return on your investment. Specific questions on taxes as they relate to your situation should be directed to your tax advisor.

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