WEALTH WISE

Are taxes lowering your investment returns?

When it comes to your investments, it's after-tax returns that really count, not what you earn before taxes. So how can you boost your posttax results? Let's take a look at a few strategies.

Contribute to tax-advantaged accounts
If you're enrolled in a qualified retirement plan, such as a 401(k) or 403(b) plan, fully fund it every year, or at least contribute enough to qualify for any employer matching contributions. Contributions are pretax, and earnings accumulate tax-deferred.

Even though the current-year tax savings of a traditional 401(k) might appeal to you, don't overlook the Roth 401(k). Your contributions won't be pretax, but earnings accumulate tax-free, not merely tax-deferred.

In terms of tax advantages, a Health Savings Account (HSA) can provide a great savings option. Contributions are pretax or deductible (though you can contribute only if you have a high-deductible health plan), plus distributions used for qualified medical expenses are tax-free. After age 65, HSA funds can be used for any purpose without penalty, including retirement, but taxes will apply.

Consider municipal bond funds
If one of your investment goals is generating income, municipal bond funds might be good choices, especially if you're in a high tax bracket. These funds invest in debt issued by states, cities, counties and public revenue authorities.

Investments in municipal debt generally are exempt from federal income taxes and can be exempt from state and local income taxes as well. However, know the tax impact of the vehicle you're considering before investing, because some bonds may lack one or more of these tax benefits, or may even be subject to the alternative minimum tax.

Also, be aware that state and municipal bonds usually pay a lower interest rate. This means their rate of return might end up being lower than the after-tax rate of return of a taxable investment. To compare the returns, you can calculate the tax-equivalent yield of the municipal bond:

Tax-equivalent yield = actual yield/(1 − your marginal tax rate).

The formula incorporates tax savings into the municipal bond's yield.

Own investments in the right accounts
It's generally best to put not only tax-free investments such as municipal bonds but also tax-efficient investments in taxable accounts. Tax-efficient investments include equity index funds, tax-managed stock funds, and stocks or mutual funds that pay qualified dividends. These investments generate less in taxable income and capital gains, so you're penalized less when tax time arrives.

Exchange-traded funds (ETFs) also can be a good choice for taxable accounts. This is because ETFs rarely make capital gains distributions, allowing investors to pay all or most of their capital gains when the ETF is sold, thereby delaying tax liability.

Conversely, tax-deferred and tax-free accounts are good places to put any investment that generates a substantial amount of ordinary income, such as taxable bond funds and certain real estate investment trusts (REITs). Keep in mind that, when you withdraw earnings from these accounts, they'll be taxed at ordinary income tax rates. Actively managed stock funds with high turnover rates are also good candidates for tax-favored accounts, given that you won't be penalized for the manager's active buying and selling.

Take smart profits and losses
If you sell a security within one year of purchasing it, any gain you earn will be classified as short term and taxed as ordinary income, at a rate as high as 39.6% in 2013.

On the other hand, if you hold a security for at least a year, your capital gain will be considered long term and taxed at 15% or 20% depending on your filing status and income. Of course, there are other risks in holding for a longer time — such as your investment losing value — so taxes shouldn't be your only consideration when deciding whether to sell.

Selling an investment at a loss allows you to "harvest" the loss and use it to offset realized capital gains. With a wide variety of mutual funds and ETFs available, you can purchase an investment similar to the one you sold, allowing you to maintain a presence in that asset category. Just be aware of the IRS wash sale rule, which prohibits taking a current loss if you sell and then rebuy "substantially identical" securities within 30 days.

If you've purchased a security at different times, it might also pay to track the potential impact of those lots for tax purposes. Selling one lot as opposed to another might trigger a much larger tax bite — or a greater tax loss that you can use to offset gains elsewhere in your portfolio.

Planning now can be valuable later
Even though few investors enjoy thinking about taxes, taking a little time to plan strategically in this area can have a significant effect on your results. Your Fifth Third Private Bank advisor can help you manage your investment portfolio for maximum tax efficiency.

Fifth Third does not provide tax advice. Consult with your tax adviser for advice pertinent to you personal situation.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.