Smart Tax Choices for Investors
By: Jeff Brown

Maybe you’ve got a tax refund coming. Perhaps you’ve been sitting on some cash waiting for the financial markets to turn around. Or maybe you want to shift from one investment to another now that the stock market is rebounding.

Whatever the reason, using a smart tax strategy can help you avoid giving Uncle Sam more than you have to, and it will boost your returns.

Many investors use asset allocation tools to decide what portion of their holdings to put into stocks, bonds and cash. Use the Morningstar (Stock Quote: MORN) and T. Rowe Price (Stock Quote: TROW) tools to get started.

The next step is to decide which types of account, taxable or tax-deferred, to use for each holding.

If your plan calls for, say, 50 percent stocks, 40 percent bonds and 10 percent cash, you probably don’t need to hit those numbers in each type of account so long as all your holdings taken together fit your goals. That gives you some flexibility.

When stocks grow faster than bonds, for example, you may need to sell some stocks and buy bonds to get back on target. To avoid a capital gains tax on stocks sold at a profit, you can confine your portfolio-balancing moves to your tax-deferred accounts like IRAs and 401(k).

That way you won’t be taxed on the gains until you make withdrawals in retirement. Sell a profitable stock from a taxable account and you’ll be taxed this year.

Also, different types of holdings are taxed at different rates.

Capital gains The maximum rate for long-term capital gains, 15 percent, applies to holdings held in taxable accounts and owned longer than 12 months. The tax is charged on the difference between the sales proceeds and the original cost.

Gains on the same investment would be taxed at the short-term capital gains rate if it was owned for 12 months or less in a taxable account. The short-term rate is the same as your federal income tax rate, which can be as high as 35 percent.

And gains on this investment would be taxed at the higher income tax rates if it was held in a tax-deferred account, regardless of how long you’d had it, since income-tax rates apply to all withdrawals from these accounts. But that tax would not be paid until money was withdrawn from the account.

Mutual funds

Actively managed mutual fund tend to generate lots of short-term capital gains, as the managers make frequent changes in pursuit of hot holdings. By using tax-deferred accounts for this type of investment, you can postpone taxes for years, perhaps decades.

On the other hand, funds that tend to result in long-term capital gains often do best in taxable accounts.

Taxes don’t have to be paid until the gains are “realized,” generally when the investment is sold. And at that point the maximum tax rate is 15 percent. Put the same investment into a tax-deferred account and will be subject to the higher income tax rates.


These are taxed at a maximum rate of 15 percent if the investment, a stock or stock mutual fund, is held in a taxable account. They’re taxed at higher income tax rates in tax-deferred accounts.


Whether it comes from bank savings or taxable government or corporate bonds, interest is generally taxed at income tax rates regardless of which type of account is used. Of course, if you don’t need the interest, using a tax-deferred account will allow you to postpone the tax bill until you make withdrawals.

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