Strategies for Tax-Efficient InvestingCharts graphs - Pong

1. Consider tax-managed or tax-efficient investment accounts and mutual funds. These are managed in ways that can help reduce their taxable distributions. Investment managers can employ a combination of tactics, such as minimizing portfolio turnover, investing in stocks that do not pay dividends, and selectively selling stocks that have become less attractive at a loss to counterbalance taxable gains elsewhere in the portfolio. In years when returns on the broader market are flat or negative, investors tend to become more aware of capital gains generated by portfolio turnover, since the resulting tax liability can offset any gain or exacerbate a negative return on the investment.

Pitfalls to avoid: Taxes are an important consideration in selecting investments but should not be the primary concern. A portfolio manager must balance the tax consequences of selling a position that will generate a capital gain versus the relative market opportunity lost by holding a less-than-attractive investment. Some mutual funds that have low turnover also inherently carry an above-average level of undistributed capital gains. When you buy these shares, you effectively buy this undistributed tax liability.

2. Put losses to work. At times, you may be able to use losses in your investment portfolio to help offset realized gains. It’s a good idea to evaluate your holdings periodically to assess whether an investment still offers the long-term potential you anticipated when you purchased it. Your realized losses in a given tax year must first be used to offset realized capital gains. If you have “leftover” losses, you can offset up to $3,000 against ordinary income. Any remainder can be carried forward to offset gains or income in future years, subject to certain limitations.

Pitfalls to avoid: A few down periods don’t mean you should sell simply to realize a loss. Stocks in particular are long-term investments subject to ups and downs. However, if your outlook on an investment has changed, you can use a loss to your advantage.

3. Keep good records. Keep records of purchases, sales, distributions, and dividend re-investments so that you can properly calculate the basis of shares you own and choose the shares you sell to minimize your taxable gain or maximize your deductible loss.

Pitfalls to avoid: If you overlook mutual fund dividends and capital gains distributions that you have re-invested, you may accidentally pay the tax twice — once on the distribution and again on any capital gains (or underreported loss) — when you eventually sell the shares.