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Tax-Efficient Investing in 2013

By Deborah Levenson, CFP ®, MBA, Vice President, Braver Wealth Management LLC (Jan 2013)

For high-income earners, 2013 brings higher taxes on both earned income and investment income. For households earning over $450,000 (or individuals over $400,000), rates on earned income will rise from 35% in 2012 to 39.6% in 2013; and long-term capital gain and dividend rates will increase from 15% in 2012 to 20% (23.8% including the new Medicare tax) in 2013.

These tax changes have at least two implications for high-earning investors. First, the higher rates will make smart asset location decisions more valuable. Second, the higher rates will make holding tax-efficient vehicles within an investor's taxable accounts more important.

"Asset location" refers to the choice of where to hold different asset classes. Generally, one should aim to hold their least tax-efficient investments in tax-deferred accounts such as retirement accounts (IRAs, 401ks, etc.). Taxable bond mutual funds, actively traded stock portfolios and real estate investment trusts (REITs) are among the least tax-efficient vehicles. All of these holdings yield significant income in the form of interest and capital gains which can be shielded in retirement accounts. On the other hand, a long-term stable portfolio of high quality equities is a very tax efficient holding. Now is a good time to re-evaluate your asset location decisions and make changes where necessary.

Within taxable accounts, the type of securities held will impact the tax bill investors pay at the end of the year. Consider replacing actively managed mutual funds with more tax-efficient vehicles like ETFs (Exchange-Traded Funds). An ETF is similar to an index mutual fund but trades like a stock on an exchange. ETFs offer a tax advantage because unlike a managed mutual fund that can have significant turnover in its holdings (often beyond 100% per year!), ETFs generally track a specific index such as the S&P 500 and therefore have extremely low turnover. This minimizes the taxes an investor owes on capital gains realized due to turnover. ETFs are also very low cost vehicles, with expense ratios as low as 0.1% per year (versus over 1% for many equity mutual funds). Using tax-efficient investments like ETFs in taxable accounts will become more valuable in 2013 and beyond.

Your tax and investment advisors can help you take advantage of both of the strategies above to reduce your tax bill under the new 2013 rules.