Regardless of the Tax Code, You can be Tax Smart!
Updates to federal tax law will affect nearly everyone in 2011. What should investors do to take advantage of the changes? Perhaps nothing.
The compromise agreement reached in Washington, D.C., will extend many current tax provisions for another year or two. What happens after that is anybody’s guess, although it’s probably safe to say there will be a lot of speculation about future tax rates.
Even so, Investment counselors caution against making changes based on potential changes to the tax code.
“Selling appreciated securities and then buying them back because you expect higher tax rates in the future can lead to regret,” said Theresa O’Hara, a senior manager in Vanguard Asset Management Services™. “For example, if the net asset value of the security should decrease between the sale and repurchase, you would needlessly incur a tax bill.”
You might feel doubly chagrined if the tax rates don’t increase after all-a situation many people may find themselves in this year.
Keep an eye on the big picture
The vigor and length of this year’s tax debate illustrate the difficulty in predicting future tax changes.
“Instead of trying to outsmart the part of the tax code that’s a moving target, we think it’s smarter to stay focused on your overall investment plan,” Ms. O’Hara said. She suggests that investors keep these questions in the forefront:
- What are my long-term investment goals?
- How are my assets allocated among stocks, bonds, and cash?
- Are my assets located in the most tax-efficient accounts?
- Am I invested in tax-efficient funds?
- Being consistently tax-smart in how you invest can help your bottom line-year after year. In fact, Vanguard studies indicate that taxes have historically reduced the average net return of U.S.stock funds by as much as 2 percentage points annually.
Of course, it’s unrealistic to expect your investments to grow and to completely avoid taxes. But no matter what happens, there are things you can do to help make the tax bite less painful:
Consider the 3 Ls: location, location, location. After you’ve set your asset allocation-the appropriate percentages of stocks, bonds, and cash for your goals-it’s good to establish your asset location. For example, consider placing the most tax-efficient holdings (such as tax-managed, index, and tax-exempt funds) in your taxable accounts, while holding tax-inefficient investments in your tax-advantaged accounts-such as IRAs or employer plans.
Maximize contributions to tax-advantaged retirement accounts. Consider putting aside as much money as possible into tax-advantaged retirement accounts such as Roth IRAs, traditional IRAs, and 401(k) plans. Roth accounts-including Roth 401(k)s-are funded with after-tax dollars, and allow tax-free growth and tax-free distributions. Traditional IRAs and employer-sponsored retirement plans can give you a break on any pre-tax contributions, and earnings can grow tax-deferred until you withdraw the assets.
Look at tax-efficient funds. Index funds are probably the most common tax-efficient option. These low-cost funds, which seek to track the performance of specific stock or bond benchmarks, typically hold all or a representative sampling of the securities that make up the index. Their buy-and-hold strategy makes them less likely to distribute taxable capital gains to you, although this is not guaranteed.
Some types of index funds take that a step further. Tax-managed funds also seek to track a particular index through a buy-and-hold strategy, and follow investment techniques, such as “harvesting” tax losses, to minimize transactions that could generate taxable gains. They also impose policies designed to discourage investors from frequently moving into and out of the funds.
And of course, income-oriented investors can consider tax-exempt municipal bond funds, which generate monthly dividend income that is exempt from federal income taxes.** (Vanguard also offers some state-specific tax-exempt funds that are exempt from state and local income taxes.) Because tax-exempt funds typically have lower yields than taxable funds, they’re often better for investors in the higher marginal income tax brackets.
Consider avoiding membership in the “frequent trading club.” Think about limiting sales of fund shares in your taxable accounts. This will allow you to reduce the capital gains you realize and defer taxes on a higher proportion of unrealized capital gains.
Rebalance tax-free, if possible. When periodically rebalancing your portfolio to get your asset mix back in line with your ideal allocation, look first to transact within tax-advantaged accounts such as traditional or Roth IRAs, where gains generated by a move aren’t subject to current taxes. If you rebalance within taxable accounts, aim to minimize potential capital gains by selling assets that have declined in value.
“It’s really best to set up a portfolio that takes advantage of these tax-smart guidelines, and then stick to your plan,” Ms. O’Hara said. “You can make a shift if your goals or circumstances change, if you need to rebalance, or if you want to diversify out of a concentrated position, not because of potential tax changes.”
