BP Holdings: 4 Tax Tips Your Accountant Will Never Tell You

I have a high regard for accountants. They have an extremely difficult job. In order to maximize tax savings for their clients, they need to understand and interpret an incredibly complicated Internal Revenue Code. Former U.S. congressman John Hostettler once said, “The Internal Revenue Code and regulations add up to 1 million words and is nearly seven times the length of the Bible.”

It's not surprising that few accountants look outside the code for tax-saving opportunities. That’s unfortunate. There’s a world of tax-saving possibilities related to investing. If your accountant is not familiar with them, your registered investment advisor should be alerting you to them.

The failure to focus on the tax efficiency of your investments can significantly affect your returns. According to a 2008 Vanguard publication, "Tax-Efficient Equity Investing: Solutions for Maximizing After-Tax Returns," taxes have the potential to take the “biggest bite” out of total returns. How much of a bite? According to research by Joe Dickson and John Shoven, “Taxes and Mutual Funds: An Investor Perspective," taxes can reduce the returns of a mutual fund by as much as a whopping 25 percent.

These tax tips will help make you a more tax-savvy investor:

1. Harvest your tax losses. No one is happy when their investment goes down in value. However, tax-loss harvesting permits you to sell investments at a loss and use those losses to offset gains on other investments. Here’s an example of how it works.

Assume you purchased a fund for $10,000 on January 1 and it declined to $5,000 on March 1 of the same year. If you decide to "harvest" the loss, it will be characterized as a short-term loss since the fund was held for less than one year. Assuming a 35 percent ordinary federal income tax, your tax savings would be $1,750. You will have reduced your economic loss to $3,250.

Tax-loss harvesting is not simple. Initially, it involves determining whether the loss is substantial enough to harvest. You also need to assess the problem of exiting the market and missing out on potentially large gains. You can avoid this problem by complying with the "wash-sale" rule, which permits you to sell a stock or mutual fund and buy a replacement stock or fund, as long as the replacement is not considered "substantially identical" in nature.

2. Invest in retirement accounts. Take advantage of a 401(k) or 403(b) plan offered by your employer. The funds you invest in these plans are pretax. You will defer taxes until you start receiving distributions. Don't forget to contribute on your own to a traditional individual retirement account or (if you qualify) to a Roth IRA. With a Roth, you will be contributing with after-tax funds, but your withdrawals will be tax-free.

3. Allocate your investments. The way you allocate funds between your taxable and nontaxable accounts can have a meaningful impact on your after-tax returns. Funds that pay out meaningful taxable distributions of dividends and capital gains should typically be placed in a tax-deferred account. Taxable bond funds should also be placed in a tax-deferred account. This will permit you to reinvest distributions and avoid recognizing those distributions as ordinary income.

Real estate investment trusts and most alternative investments should generally be held in tax-deferred accounts to defer taxes on distributions.

Active trading of your investments is generally a bad idea because it runs up transaction costs, which reduces returns. However, if you must actively trade, put those investments in a tax-deferred account so you can buy and sell without tax consequences.

Individual stocks that you intend to keep for a long time should be placed in an after-tax account. Index funds and stock index exchange-traded funds are also good candidates for your after-tax account.

When deciding how to allocate investments between your taxable and nontaxable accounts, taxes should not be your sole consideration. Investments in tax-deferred accounts have restrictions on withdrawals. You may incur a penalty if you withdraw these funds earlier than permitted. You want to be sure you have enough funds in your taxable account so you can meet your needs, without accessing your retirement accounts.

4. Buy index funds. As a general rule, index funds (where the fund manager seeks to replicate the returns of the designated index and there are less transaction costs) that track a broad index (like the Standard & Poor's 500 index) and comparable ETFs are very tax-efficient. Most actively managed funds (where the fund manager attempts to beat the returns of the designated benchmark) trade more than index funds, incurring higher taxes. They are less tax-efficient.

The same Vanguard study calculated the tax costs of actively managed funds and index funds. The study measured the tax cost for 15 years ended Dec. 31, 2007. It found the median tax cost of domestic actively managed funds was higher, by 0.83 percent annually, than the tax cost for index funds.

This significant difference in tax costs is a major reason why the same study found that "indexing has historically provided higher after-tax returns than have actively managed mutual funds.”

Here’s the bottom line: If tax efficiency is important to you, consider investing in index funds, ETFs or passively managed fund.