Volumes have been written on taxes and investments, and the strategies can be quite complex. Understanding some basic principles, though, is important to gaining the greatest long-term benefits.

Mutual confusion – Mutual funds typically have two types of taxable events. The first is the annual distribution to shareholders of all income and capital gains generated by the fund’s investment activities. These distributions are made on a per-share basis and have no relation to how long the shares have been owned, and tax is owed on these amounts even if they are reinvested in additional shares of the fund. This is why it is wise to contact a fund before making a large purchase near the year-end distribution date, which could mean a big tax bill even though the investment was newly purchased. The good news is that reinvested distributions will increase the overall cost basis of the investment.

The second taxable event is when shares of the fund are sold, at which point any capital gain or loss is determined by comparing the sales price with the original investment cost adjusted for reinvested distributions along the way. So, while it is no fun to pay taxes on money you did not actually receive, reinvestment can have a dramatic effect on reducing taxes when the fund is sold.

Deferred or free – Most tax-advantaged investments are actually tax-deferred rather than truly tax-free because the taxes due are simply postponed. In retirement accounts with pre-tax contributions like traditional IRA’s, 401k’s, SEP IRA’s and profit-sharing plans, the investments grow without any tax liability but any amount taken out of the account at retirement is taxed as ordinary income, regardless of whether the growth was a result of investment income or capital gains. For annuities, the amount of withdrawals in excess of the original investment, determined on a pro-rata basis, is also taxed as ordinary income.

The few truly tax-free investments on which no federal taxes are due include the income on municipal bonds, retirement withdrawals from Roth IRA’s and the limited capital gain on the sale of a primary residence (and a primary residence should not really be viewed principally as an investment).

After-tax returns – In their own defense, mutual fund managers maintain that many of the shareholders in their funds are in tax-deferred circumstances, so the managers focus on their investment objective without worrying about any tax implications for the shareholders. It is worthwhile, however, to be aware of the impact taxes have historically had on fund shareholders, and providers such as Morningstar offer tax analysis on funds. A stock mutual fund can have a reduction of as much as 5% of its average annual return due to taxes, and funds that more frequently buy and sell their holdings usually have a greater tax bite. Fund companies and information services can also identify the impact of unrealized capital gains which could be distributed should the fund sell those investments. All other things such as risk, expenses, investment objective and long-term performance being equal, a more tax-efficient fund with less unrealized capital gains is a better choice.

There are other tax-efficient investment vehicles, which typically means less current tax liability. Individual stocks offer more opportunity for capital growth, especially growth companies which pay little or no dividends. Index mutual funds, including exchange-traded funds (ETF’s), seldom change their investment holdings and so they rarely make capital gains distributions. And “tax-managed” funds specifically consider the tax impact on shareholders when making investment changes.

Asset location – Given the differences between capital gains and income tax rates, the type of account in which investments are held is significant. Ideally, income-oriented investments should be held in tax-deferred accounts because both current and future taxes will be at income tax rates. On the other hand, capital-growth investments are best held in a taxable account, where the current tax rate (the capital gains rate) could be as much as 57% lower than the future income tax rate. If the majority of the overall portfolio is in tax-deferred accounts, don’t despair. Investing for the greatest total return – income and capital growth – consistent with your tolerance for risk is still the best approach.

Conventional wisdom – Even these basic ideas are based on two fundamental assumptions which, like all tax rules, could easily change over time. The first is that the tax rate on long-term capital gains, currently a maximum 15%, remains lower than the marginal tax rate (the rate on the next dollar of income) on income for many taxpayers. (This lower rate currently also applies to stock dividends, but the capital gains rate has larger impact.) With government spending continuing to increase, the lower capital gains rate could be under pressure, but even a married couple with taxable income over $63,700 has a marginal tax rate of 25%, so there is some room for the capital gains rate to increase and still be advantageous.

The second assumption, which is far more entrenched, is that an investor’s income tax rate in retirement will be lower than during the working years. Since 1980 the top marginal federal tax rate has fallen from 70% to the current 35% and has varied from 35% to 40% over the past fifteen years. At the same time, tax brackets have widened, the availability of tax credits has expanded and Social Security benefits are now more likely to be taxed. That same married couple with taxable income of less than $63,700 has a marginal income tax rate of only 15%; with deductions and credits, their gross income could easily be over $100,000. That 15% bracket may prove to be the lowest marginal rate they will encounter in their lifetime.

Still, the best we can do is to consider the facts as they are, and that certainly applies to taxes and investments. While having a long-term plan, making funds available for investment and maintaining the proper diversification are most important, there are simple ways to avoid paying the taxman more than is necessary.

March 2008