Timely Income Tax Tips and Investment Strategy from DFW’s Kendall Financial (Flower Mound, TX)

“I recently came across an article written by Christine Benz, Morningstar’s Director of Personal Finance.  It has some solid  advice for reducing income taxes, and enhancing your investment strategy.  Please feel free to call me at 972-874-8757 if you want to discuss any of the tips suggested by Christine:”

With the market being the rollercoaster that it is, what can you really control? Certainly, you can save more. You can also make sure your security selection is as good as it can be. You can also control your own costs, including any transaction costs you pay to buy and sell securities as well as what your underlying investments are charging you.

Another arrow in your quiver is limiting Uncle Sam's take. Many taxpayers assume that there's no point in trying to outwit the IRS, but there are many ways to legally shave your income tax costs. With April 15 fast approaching, here are 10 ways to make your portfolio more tax-efficient.

1. Make room for stocks.
Stock investors pay taxes on capital gains only when they sell.  For example, if you hold a non-dividend-paying stock for 20 years and its price goes from $20 per share to $240 per share over that period, you'll owe income taxes on the $220/share appreciation in the year in which you sell, but you won't owe any taxes along the way. That tax-deferred compounding is an important advantage for stocks.

2. Get to know tax-managed funds.
Not every mutual fund is a bad deal for investors' taxable accounts. Tax-managed mutual funds are specifically managed to limit the tax collector's cut. To do so, they use a variety of techniques, but most work to sell losers in an effort to offset any capital gains they realize; many also limit their exposure to dividend-paying stocks.

3. Consider index funds and ETFs.
Exchange-traded fund investors trade shares among themselves, not with the fund, so ETF managers don't have to sell securities to pay off redeeming shareholders. Only large investors buy and sell directly from the funds, and exchange-traded funds can satisfy those redemptions by giving those large investors baskets of their underlying portfolios' stocks instead of cash.

4. Make use of tax efficiency data but beware their limitations.
While these figures can be helpful in determining whether a fund is appropriate for a taxable account, it's important to recognize that, like fund returns, they're backward-looking and aren't foolproof in how a fund may behave in the future.

5. Make room for municipal bonds.
Bonds and bond funds can be an even bigger landmine than stocks for taxable investors. Income from municipal bonds, municipal bond funds, and money market funds is taxed at your ordinary income-tax rate, whereas dividends and capital gains receive more favorable treatment from the IRS.

6. Pay attention to "asset location."
Generally speaking, you'll want to jettison anything with a very high income stream over to your tax-sheltered accounts so you won't be hit on that income year in and year out. Ditto for any investment that involves very high turnover and/or derivatives, such as some of the commodities funds that have grown so popular of late.

7. Beware ticking tax time bombs.
If you're about to buy a fund from an asset class that has performed particularly well over the past several years-- such as emerging markets, foreign small caps, and natural resources--pause and make sure you're not chasing performance. And if you are determined to proceed, make sure you're doing so in a tax-savvy way.

8. Take a fresh look at your 401(k) options.
Take advantage of any means you have of sheltering your investments from taxes. The Roth 401(k) is super for savers who earn too much to contribute to a Roth IRA.  The Roth 401(k) requires you to pay taxes on your contributions now, but you won't have to pay tax when you withdraw the money in retirement.

9. Consider a traditional IRA.
Beginning in 2010, investors at any income level will be able to convert a traditional IRA into Roth IRA. And if you convert in 2010 (and 2010 only), you'll be able to spread the tax hit over 2011 and 2012.

10. Keep it in perspective.
Taxes are just one of many factors to bear in mind when making retirement and investment decisions, and they should almost always take a backseat to an investment's merits and whether it fits within the context of your portfolio. After all, you want to maximize your aftertax returns--minimizing your tax bill is just a tool to that end goal.

Finally before you make any tax-related changes to your investment portfolio, it's also crucial to consider what taxes and transaction costs you'll incur to make those changes.