Obama’s Tax Deal in Progress, Boglehead Taylor Larimore Offers Year-End Tax Tips

Taxes are the single biggest drag on investor returns, says Taylor Larimore, the well-known moderator of the Bogleheads’ investing board. Now with Washington having come to some agreement on taxes, and moving toward extending the current tax status quo for two years, there’s no excuse for not putting some attention on your taxes. As a former IRS Revenue Officer, Larimore has a special interest in tax planning as it relates to mutual fund investing. He recently published his 2010 year-end tax tips for investors, and tells Portfolioist in an email interview (below) that sticking to smart tax planning, can make a big difference.
Along with Mel Lindauer, Larimore is a co-author of a number of Boglehead investing books, including The Bogleheads’ Guide to Investing, and a strenuous advocate for index investing. An investing mentor to many, at 86, Larimore isn’t only focused on numbers. He remains an avid sailor and is out regularly on the waters around his Miami home, the reward of a life of watching his investment costs and remaining disciplined. Portfoliost: It looks like Washington has come to an agreement to extend the current tax regime two years. Does that resolution affect your recommendations for how an investor approaches mutual fund and ETF taxes in 2010? Larimore:

If the new law passes, as expected, it will help remove uncertainty so that my “Tax-Tips” should still apply–at least for two more years.

Portfolioist: The stock market is up so far this year, does that mean more investors need to think about certain tax consequences? If so, which ones, and what should they be doing? Larimore:

A basic knowledge about taxes is essential if one wants to have the highest after-tax returns. This is the only return that counts. A successful investor must have a basic knowledge about how taxes reduce their fund returns and how to minimize their detrimental effect. Right at the top of tax-efficient portfolio planning is to nearly always locate taxable bonds in tax-deferred accounts and put stock funds in taxable accounts. Also, it is very important for investors to use only tax-efficient funds in taxable accounts. Investors can go to Morningstar and compare tax-cost ratios and after-tax returns of various funds. Most, but not all, index funds and ETFs are tax-efficient and suitable for taxable accounts.

Portfolioist: Over the past two years many average investors have moved a sizable chunk of their money out of equities and into bonds or cash. If someone did that this year, what tax issues might they be facing? Larimore:

I feel sad for investors who sold stocks in 2008 and 2009 when the S&P was around 800. Today the S&P 500 Index is over 1200 and this does not count dividends. It is important to have a long-term asset allocation plan–then stay-the-course during both good times and bad. Jack Bogle has stated that “stay the course” is the most important advice he can give. Regarding the “tax-issues,” there is often an upside when we sell at a loss. I’m talking about harvesting tax-losses in taxable accounts. These losses are reported on our tax return and can be used to offset capital-gains. If there are no capital gains during the year of sale, they can be used to reduce up to $3000 of taxable income. Losses can be carryforward forever until used up. Tax losses are very valuable and should usually be taken when available otherwise they may be lost forever.

Portfolioist: If you sell taxable funds before the distribution date, do you avoid all taxes on those distributions even if you’ve owned them most of the year? Larimore:

Yes, you would owe tax on the entire distribution even if you owned the shares on just the distribution record date. Avoid the distribution if possible.

Portfolioist: On your list of tax tips, you say that this can be a good time to rebalance. Why is rebalancing a tax matter? Larimore:

In tax-advantaged accounts, rebalancing is not a tax matter. Tax-advantaged accounts like IRAs and 401Ks are a good place to rebalance. In taxable accounts, it may be necessary to sell over – performing funds. In such a case, a taxable capital gain is likely. The best way to rebalance back to your target allocation is to use contributions to add to underperforming funds and take withdrawals from over performing funds. If this is insufficient to get close to target, the next best thing is to rebalance within tax-advantaged accounts.

Portfolioist: More broadly, you have over 50 years of investing experience. You have also made over 35,000 combined posts on the Morningstar and Boglehead forums, aimed at helping other investors invest successfully. In a few words, what are your suggestions for the average investors today? Larimore:

To be a successful investor, this is my best advice: Read at least one good* book on the subject of mutual fund investing; save regularly; develop a personal asset-allocation plan based on your goals, time-frame, and risk-tolerance; use a few broad market index funds containing thousands of world-wide securities, keep costs low (including taxes); avoid mistakes and stay-the-course.

*Here is a link to “good” books Taylor recommends.

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