4 steps to tax-efficient investing

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(MoneyWatch) Investing is easy -- taxes aren't. Much of my job as a financial planner involves directing my clients toward tax-efficient investing, so my background as a CPA comes in handy. If you want to improve your after-tax situation for 2012, there are some things you need to start doing today, as detailed in these four easy steps:

Step No. 1: Buy low turnover funds

Active mutual funds buy and sell stocks regularly. Now that U.S. stocks are at an all-time high, when your fund sells a stock at a gain, you get to pay the taxes. That's true even if the price of your active mutual fund is lower than what you paid for it. You get an unrealized loss you can't deduct and capital gains you have to pay to the IRS.

For example, the Brandywine fund (BRWIX) holds a stock for an average of five months, according to Morningstar. In up markets, you can expect to pay a bunch of short-term capital gains taxed as ordinary income. The Vanguard Total Stock index fund (VTSMX) has virtually no turnover and generates little or no capital gains.

Step No. 2: Harvest your losses

Tax-loss harvesting is key to tax-efficient investing. In 2008 and 2009, I was selling my stock index funds even as I was buying slightly different ones to get back to my target allocation. That's because the IRS has a so-called wash sale rule that says you can't buy back the same fund within 30 days, so you have to buy something different to stay in the market.

In the world of indexing for example, if you own the Vanguard FTSE All-World Ex-US index fund (VEU) at a loss, you could buy the Vanguard Total International Index Fund (VXUS). The only difference is that you've now added small-cap companies to your international portfolio.

Asset location, location, location
Clarity on Roth conversions

In the depths of the stock market plunge, I had many clients who questioned the need for tax-loss harvesting, as they would never use up the lifetime carryforward that's available after the $3,000 maximum annual loss allowed by the IRS. Markets recovered with a fury and those that used this strategy saved a bundle. I can tell you that I quickly used up the tax losses I harvested back then.

Step No. 3: Asset location

After you select an asset allocation that's right for you, locate the assets where they are more tax efficient. Investments taxed at the highest rates belong in your tax-deferred or even your tax-free Roth accounts. Those include taxable bonds, CDs, and REITs. Efficient investments such as broad stock index funds belong in your taxable accounts. That's because dividends are (for the time being) taxed at a 15 percent rate, and the capital gains can be deferred by holding the investments.

Step No. 4: Don't confuse the goal

I regularly remind clients that their goal is not to minimize taxes, but rather to maximize what they keep after paying taxes. So if you are in a low tax bracket, you may be better off dumping the municipal bonds and retaining more wealth after paying taxes. And no matter what your tax rate is, you are almost certain to come out better by paying down or even paying off the mortgage. Clearly, you are unlikely to find a safe bond portfolio (which is taxable) that pays as much as your bank is charging you on the mortgage.

These four steps can dramatically improve your finances. It's rare to be able to have your cake and eat it too, but follow these steps and you can get both lower costs and more tax-efficient investing.

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    Allan S. Roth is the founder of Wealth Logic, an hourly based financial planning and investment advisory firm that advises clients with portfolios ranging from $10,000 to over $50 million. The author of How a Second Grader Beats Wall Street, Roth teaches investments and behavioral finance at the University of Denver and is a frequent speaker. He is required by law to note that his columns are not meant as specific investment advice, since any advice of that sort would need to take into account such things as each reader's willingness and need to take risk. His columns will specifically avoid the foolishness of predicting the next hot stock or what the stock market will do next month.

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