3 ways to cut your investment tax bill

Are you paying a lot of taxes on your investments? Although it's too late to change your 2013 taxes, you can do a few things for 2014 and beyond.

First, buy tax-efficient investments. Mutual funds that turn over their portfolio pass through the taxable gains to their holders. Many active funds buy and sell stocks so frequently that their average holding period is less than a year. Investors get a 1099 from the mutual fund family showing they must recognize short-term and long-term capital gains.

Believe it or not, that can even happen in years when the fund value declined. A low-cost index fund such as the Vanguard Total Stock ETF (VTI) has very little turnover and allows the investor to control when and if she recognizes the gain.

Second, locate your assets in a tax-efficient manner. Once you select an asset allocation, locate the assets so that you pay less in taxes. Tax-efficient vehicles, such as the index fund mentioned above, belong in your taxable accounts. Anything taxed as ordinary income -- such as bonds, CDs and REITs -- generally belongs in your tax-deferred accounts. The Roth tax-free wrapper is much more dependent on each investor's situation, but often a REIT works here since distributions are taxed as ordinary income and have more opportunity to grow than bonds.

Third, harvest your tax losses. Losses hurt, and we don't like to recognize them. But those losses have great value when it comes to tax time. I recommend selling anything you're holding at a loss and simultaneously buying a similar investment. By doing so, one avoids being out of the market but not falling into the IRS wash rule, which says you can't recognize the gain if you buy the security back within 30 days. So, if your Vanguard Total Stock Index fund tanks, you can sell it and buy the Schwab Broad Market Index Fund (SCHB), which follows a similar total U.S. stock index.

There are many ways to be even more tax-efficient. A strategy I apply for my own portfolio is to use multiple Roth conversions with the goal of paying taxes sooner and saving far more in taxes later. And if you are in retirement, using your money to live on, it's critical. As a general but very loose rule, you may want to use taxable dollars first, tax-deferred money next and Roth money last.

I've always said investing is simple, but I've never said taxes are. There are a multitude of exceptions to the guidelines above in individual situations depending on variables such as current and future income, tax-loss carryforwards and the like.

Taxes are costs, too, and tax-efficient investing is critical to building a nest egg. We all like to pay less in taxes, but never forget that the much better goal is to make more money after taxes.

Allan Roth

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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