Tuesday, March 22, 2016

Take advantage of legal investment methods to reduce taxes

FROM http://newsok.com/

From July 20 to August 24 last year the Dow Jones Industrial Average and the NASDAQ Composite Index dropped 12.5 percent and 18 percent, respectively.
That monthlong slide left many investors feeling like a deer caught in headlights. There weren't many escape routes, and most investors, being long-term oriented, elected to simply ride out the reversal. Besides, what else could you do? While I believe in the wisdom of looking beyond temporary setbacks, they sometimes present opportunity in an unlikely area: taxes.
Since the market pummeled most stocks, especially tech and oil-related companies, investors had the opportunity to take capital losses by selling off certain stocks and mutual funds in their taxable accounts, then moving that money to similar stocks or funds. Those who applied this strategy remained in the market for the long run, but created tax losses that reduce current and future taxable gains or lower ordinary income.
For instance, if you purchased Chevron in late April at $112, you had a 36 percent loss by late August, as it dropped to $71. At the same time, Exxon dropped 24 percent from $89 to $68. So, an investor could have sold Chevron, claimed the loss, and bought Exxon at the same time. Thus, the investor remained in the market but reduced his current and, possibly, future taxable gains. After waiting 31 days to avoid a wash sale, the investor can buy Chevron back.
This technique is known as a “tax swap.” It can be as helpful now as it was 17 years ago, when I first introduced it as one of my “10 Do's and Don'ts of Investing:”
“Do take advantage of legal methods to reduce taxes.”
Let's test this sixth rule as we have already tested my first five to see how practice has met theory since 1999. This is what we have so far:
• Do diversify
• Don't procrastinate
• Don't try to time the market
• Don't chase past winners
• Do have an investment plan
 You need to consult with your accountant regarding any specific tax issues.
Incidentally, many people wait until the end of the year to do tax planning when they should think about it all year long. Keeping more of your hard-earned money in your account and away from the government will boost your overall rate of return. It's perfectly reasonable to use tax considerations as part of your approach to investing. To paraphrase one of the most respected federal judges of the last century, Judge Learned Hand, there is no obligation for a U.S. citizen to pay more in taxes than legally required.
So what are some of the more common ways to avoid or defer taxes? First, max out your contributions to your retirement plan if you can, because it reduces your annual taxable income. This is especially true with 401(k) plans that have an employer matching contributions. That's like free money! Consider contributions to your retirement as one of your most important monthly bills.
Second, consider tax-advantaged accounts like tax-sheltered annuities and variable life insurance policies. These offer market exposure without the headache of taxable gains or losses each year, as the funds are not subject to tax until withdrawn.
Similarly, although you forego the tax deduction today, contributing to a Roth IRA, if you are able, can savor years of growth without a tax burden. In addition, Roth IRA earnings can be withdrawn tax free after age 59½. That's right. You can, potentially, have investment earnings tax free.
Third, don't forget about tried and true tax-free municipal bonds. This is one area that has changed over the last 17 years. Back in 1999, I said “rates are now higher than they have been in several years.” Obviously this is no longer true. So be careful. With interest rates so low, any increase in rates could drop the value of your bond. Your risk is reduced if you plan to hold them to maturity.
Here's the take away: Be knowledgeable and open-minded about tax strategies the next time the market gets beaten up. Then, keep your wits about you and look for a chance to make lemonade out of lemons.