Tax-Efficient Investing

An investment portfolio’s performance is influenced primarily by the asset allocation (investment) strategy the investor employs. An asset allocation strategy is usually based on the investor’s time frame, tolerance for risk, targeted return, and need for liquidity and cash flow. Tax issues are generally a secondary consideration when investing; nevertheless, investors make several decisions that impact the after-tax return earned on a portfolio. Following is a discussion of tax issues that affect many individual’s investments.

Emergency Reserves: Most financial plans call for an emergency reserve fund that will cover the individual’s living expenses for 3 to 6 months. Investment products that have a high level of liquidity and minimal risk (for example, money market funds, short-term certificates of deposit, short-term government securities) are popular choices for emergency reserve funds. Among other factors, investors should compare after-tax rates of return when selecting between these investment alternatives.

Taxable vs. Tax-Exempt Investing: The earnings from most investment products are taxable; however, some investment vehicles offer tax-exempt income. Deciding between a taxable and a tax-exempt investment requires an analysis of after-tax rates of return -- a calculation that is dependent on the investor’s marginal tax bracket (federal and state). The following chart compares the after-tax rate of return for a taxable bond with the return for a tax-exempt bond:

After-Tax Rate of Return
Earning this much on a tax-exempt investment...	...Is the same as earning this much on taxable investments.
Tax-exempt yield	Equivalent Taxable Yield at Indicated Marginal Tax Rate
Tax-exempt yield	15%	28%	36%	39.6%
4%	4.7%	5.6%	6.3%	6.6%
5%	5.9%	6.9%	7.8%	8.3%
6%	7.1%	8.3%	9.4%	9.9%
7%	8.2%	9.7%	10.9%	11.6%
8%	9.4%	11.1%	12.5%	13.3%

Tax-Deferred Retirement Accounts: The appreciation realized on investments held in a retirement account will be taxed as ordinary income (rather than as capital gains) when withdrawn from the account. Capital gains are taxed at a maximum rate of 28%, while ordinary income is taxed at a maximum rate of 39.6%. Several years of tax-deferred growth will usually offset the difference between capital gains and ordinary income tax rates. Additionally, withdrawals from tax-deferred retirement accounts are often made when the investor is in a lower tax bracket (for example, after the investor has retired).

Stock Funds: The extent to which a mutual fund manager buys and sells securities (measured by the fund’s turnover rate) can have a significant effect on an investor’s after-tax return. Mutual funds are required to distribute their earnings (including capital gains from selling appreciated stocks) to investors annually. Capital gains realized by mutual funds, therefore, are taxable income for the fund’s shareholders (i.e., are "passed through" to the shareholders). Investing in mutual funds that have low turnover rates will minimize taxable capital gains distributions.

If an investment in a mutual fund is made before a capital gains distribution date, the new investor is subject to the taxes on the capital gains the fund realized and distributed. If the investment is made after the distribution date, the new investor avoids the taxable distribution. Capital gains distributions are usually made in November or December. Many funds will inform potential investors of the date of an upcoming capital gains distribution, and will provide an estimate of the amount of the distribution.

International Stock Funds: Mutual funds that invest in foreign stocks have unique tax implications. Global or international funds generally must withhold foreign taxes on overseas income distributed to shareholders. U.S. investors in international stock funds may be able to claim a credit for foreign taxes withheld that will reduce their U.S. federal tax liability. Foreign taxes withheld on investments in a retirement account, however, do not qualify for the foreign tax credit.

Gifts to Children: Transferring assets to children may reduce overall taxes. Savings are greatest when income generated by the transferred assets is deferred (or minimized) until the child reaches age 14. Growth-oriented stock mutual funds (with low turnover rates) and zero coupon bonds are types of investments that will help defer income.

Direct gifts allow the child to have immediate control of the assets. If a custodial account is established (utilizing the Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act), the child will not be able to withdraw funds from the account before reaching the legal age of majority (18 or 21, depending on the state). Income earned on direct gifts and custodian accounts is taxable to the child.

Setting up a trust for a child (adult or minor) allows the parent to dictate when the child will have access to trust assets. Trusts are appropriate when the parent wants to delay the child’s receipt and control of the trust assets beyond the legal age of majority. For 1997, the first $1,650 of income generated in a trust is taxed at 15%, and the top marginal tax rate (39.6%) applies to income exceeding $8,100.

Tax Advantaged Investments: Certain investment products rely heavily on tax benefits to generate competitive rates of return. Investments that have poor economic fundamentals, but that are designed to take advantage of certain tax rules, have generally been poor performers.

These are some guidelines to consider when making investment decisions. Your financial advisor can also provide information, and should be consulted before any action is taken.

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	Tax-Efficient Investing Personal Finance Advisor by Deloitte & Touche OnLine April 21, 1997