Savvy investing minimizes taxes

Because taxes often lower the actual return on your investments, the first step in becoming a tax-savvy investor is learning how to better understand the implication taxes have on your investments. Essentially, the two main ways in which you can minimize your taxes through investment strategies are by deferring your taxable income and by increasing your deductions. Let's take a look at a few strategies for effectively making one or both of these things happen.

o Take advantage of tax-deferred savings. One tax-savvy investment technique is to make regular contributions to tax-deferred savings plans. The more money you place in a 401(k) or a qualified individual retirement account, the more you reduce your taxable income and lower your tax bill. Plus, the money you've invested can increase free of taxes. The basic idea is that income taxes will not be due until you take distributions from these accounts.

In addition to retirement savings plans, there are also tax-managed mutual funds, municipal bonds, money market funds and retirement options for the self-employed. Generally, only higher-bracket taxpayers are interested in municipal bonds because of their relatively lower yields. Depending on your individual situation, these may save you money by reducing your overall tax burden. Be sure to consult a tax professional to determine the most effective investment and savings options for your portfolio.

o Balance capital gains and losses. Capital gains are the amount by which an asset's selling price exceeds its basis, which is usually its initial purchase price. Conversely, a capital loss occurs when the selling price of an investment is less than its basis. Any profits made from capital gains are generally subject to taxes or lower rates; however, you can offset realized gains with realized losses.

One effective tax move for reducing capital gains taxes is to sell losing investments in the same year, thereby offsetting the capital gains and reducing your tax burden. Even if you don't have gains, you can offset up to $3,000 of capital losses against ordinary income tax. Any unused losses may be carried over into future years.

o Beware of short-term gains. Another tax-friendly strategy for reducing capital gains taxes is to hold your investments for 12 months or longer when possible. Long-term capital gains - those held for more than one year - are taxed at a lower rate than short-term capital gains, which are held for less than a year. When you consider both the long- and short-term tax implications, the savings can add up quickly and be worth much more than you think.

o Take steps to increase deductions. The more deductions you can claim, the smaller your taxable income will be and the fewer taxes you will owe. Don't overlook possible deductions; three common large deductions are mortgage interest, state taxes and gifts to charity.

Tips for 2006

As you prepare your 2005 returns, it's a good time to plan for 2006. Consider making a few savvy tax-saving moves and you may be able to minimize the impact Uncle Sam has on your investment portfolio this year.

After all, it's not how much you earn but how much you keep that matters most.

1. Max out your retirement savings plan. If you aren't contributing the maximum amount allowed, at least be sure to contribute enough to get your employer's matching contribution. You don't want to miss out on free money.

2. Track all of your charitable contributions. All donations to qualified charities can be included on your itemized deductions. So, clean out those closets and be sure to get a receipt.

3. Give financial gifts to family members. If you have substantial assets, you can lower taxes on your estate by giving cash to your children and grandchildren every year. In 2006, you can give up to $12,000 to each person free of gift taxes (up from $11,000 in 2005). That gift helps to decrease the size of your estate, which in turn means lower estate taxes. And, as an added bonus, the gift is not taxable to the recipient.

Although tax planning should be considered an integral component of your investment planning process, much depends on your personal situation. You may not be able to implement all of the strategies listed here, but you should be aware of the options that are most effective for your portfolio.

Because tax laws are complicated and change frequently, be sure to consult a qualified financial adviser who can help you understand and implement tax-smart investment strategies to help maximize growth and increase returns.

Paula Dougherty, CFP®, ChFC, CLU, is a certified financial planner with Ameriprise Financial in Springfield. She can be reached at paula.j.dougherty@ampf.com or ameriprise.com.

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