Choice of investment options affects taxes

There are several points to consider when evaluating the tax efficiency of different investments:

• Bonds. There are two main types of bonds: tax exempt and taxable. Municipal bonds, which are issued by state and local governments, pay interest that is usually exempt from federal income taxes. However, income from certain types of municipal bonds may be taxable for taxpayers who are subject to the alternative minimum tax.

Taxable bonds typically are issued by the U.S. government or by a corporation, and they are generally federally taxed. However, certain government bonds may be tax-exempt at the state level, subject to state law.

When evaluating which bond is most appropriate, one factor to consider is its yield. First, calculate the taxable-equivalent yield for the municipal bond. Taxable-equivalent yield is the yield that a taxable bond would have to provide to match the yield on a bond whose interest income is exempt from federal (and state) income taxes. For example, assuming that you are in the 25 percent federal income tax bracket, a corporate bond would have to provide a 5.3 percent yield (excluding state tax) to match a 4 percent yield on a municipal bond. A decision between these two bonds would be tax neutral at these rates. Keep in mind that if both bonds are sold before they reach maturity, their yields and market values will fluctuate, and they may be worth more or less than their original cost.

• Stocks. If your goal is tax efficiency, you may want to choose a stock that pays little or no dividend in order to reduce your current taxable income. Investors who don’t need the dividend income usually hold these stocks for their growth potential. The stock grows tax-deferred until it is sold. By determining when to sell the stock, you are able to manage gains and losses. Also, if you hold the stock for more than one year, it will be eligible for the long-term capital gains rate (maximum 15 percent), which is lower than the ordinary income tax rates applied to stock held for one year or less.

If you need an income-producing stock, you can choose one that will pay dividends that qualify for the reduced dividend tax rate, as compared to your ordinary income tax rate. These qualified dividends are currently taxed at long-term capital gains rates.

It is important to remember that the return and principal value of your stock, upon redemption, may be more or less than the original investment, based on changing market conditions.

• Mutual funds. You may be able to reduce your taxes by choosing funds with minimal yields and low turnover. The yield will provide an indication of the amount of interest and dividends distributed by the fund. The turnover ratio measures the fund’s trading activity. Funds with higher turnover ratios typically distribute more capital gains, which are taxable to the investor. Investing in mutual funds involves risk, and you should be aware that your principal and investment return in a mutual fund will fluctuate in value and may be worth more or less than its cost when redeemed.

Just because an investment offers tax advantages doesn’t mean it’s appropriate for your portfolio, so before making any decisions, you should consider your goals regarding return on investment, time horizon and risk tolerance. Your financial consultant can help you decide what investments fit best into your overall portfolio.

Timothy M. Reese is senior vice president, investments, with A.G. Edwards & Sons Inc.

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