Tax Savvy: Strategies to Lower Your Bill

By JAN M. ROSEN

FEW paper chases can match the marathon that Americans must complete every tax season. Even so, the most financially savvy do not equate filing their returns with crossing a finish line.

Rather, they take time to study their returns and all the underlying documents, especially those relating to mutual fund holdings and other investments, to see whether they should fine-tune their financial plans. But first, it’s important to understand these basics concerning investments in regular taxable accounts and in tax-deferred retirement plans like I.R.A.’s and 401(k)’s:

• Long-term capital gains and most dividends paid by stocks or stock mutual funds in regular accounts are taxed at 15 percent for people in most tax brackets and not at all for those in the 10 and 15 percent brackets. Interest, including that from bond funds, is taxed at regular rates.

• Even if dividends and capital gains are reinvested, shareholders are still liable for taxes on them for the year in which they are declared.

• Assets in traditional qualified retirement plans and I.R.A.’s are not taxed until they are withdrawn from the accounts or paid out in retirement. But when money does come out, it is taxable as regular income, even if some of it results from capital gains and dividends.

• For Roth I.R.A.’s, after-tax money goes in and retirement distributions are generally tax-free.

Five tax and financial professionals discussed the current market and fund climate to help you do your own fine-tuning. Here are some of their recommendations:

BEWARE OF HUGE CAPITAL GAINS “In 2011, you’ll probably see a lot higher capital gains than in recent years” on mutual fund statements, said Christopher Davis, a senior fund analyst at Morningstar.

In 2009 and 2010, both strong years for stocks, many fund managers carried forward losses from 2008. But by now many funds have used up their loss carryforwards, he said, so investors who hold funds in regular accounts may owe capital gains taxes for 2011.

For people who have both regular and retirement accounts, he said, it is generally wise to place bond funds in 401(k)’s or I.R.A.’s, while equity funds may be better in Roth or regular accounts.

For taxable accounts, he listed several tax-efficient funds — meaning funds use techniques like minimizing the number of trades and harvesting losses to offset gains: Vanguard Tax-Managed Capital Appreciation, Vanguard Tax-Managed Growth and Income,Vanguard Tax-Managed Small Cap, Selected American, Davis New York Venture, the Clipper Fund, Vanguard Primecap Core, Primecap Odyssey Growth, the Fairholme Fund, Fidelity Spartan International Index and Vanguard Total International Stock Index.

CONSIDER E.T.F.’S Jason T. Thomas, chief investment officer at Aspiriant, a fee-only wealth management firm with offices in San Francisco and Los Angeles, notes that investors who buy mutual fund shares may find at year-end that they are liable for capital gains accrued before their purchase. This problem does not occur with exchange-traded funds, for which investors face capital gains taxes only on their own actual profits.

Some investment management firms promote separately managed accounts to affluent clients in order to avoid the tax inefficiency of mutual funds. But Dr. Thomas and Dr. Alex Ulitsky of BlackRock, the investment management firm, have done computer simulations to compare the tax efficiency of E.T.F.’s and separately managed accounts. They concluded that after-tax returns are generally better with an E.T.F. that pursues “the same investment and tax-management strategies” — in part because of higher management fees on the separate accounts.

DON’T REINVEST FUND DIVIDENDS IN TAXABLE ACCOUNTS That’s the advice of Kurt Brouwer, chairman of Brouwer & Janachowski, an investment management firm in Tiburon, Calif., who notes that reinvested dividends should be added into the shareholder’s cost basis for tax purposes. But, he said, that can entail a lot of paperwork, so some fund holders who don’t keep good records unwittingly pay taxes twice on reinvested dividends — first, after they receive a Form 1099 each year and again years later, when they sell their shares.

ESTABLISH AN I.R.A. FOR 2010 Eligible taxpayers who fund an I.R.A. by this year’s April 18 filing deadline can lower their 2010 taxes, while helping to prepare themselves for a secure retirement, said Avery E. Neumark, a retirement specialist and partner in the New York accounting firm Rosen Seymour Shapss Martin & Company.

And self-employed people who file for an automatic six-month extension to file their returns can set up a Simplified Employer Pension I.R.A. until Oct. 17, Mr. Neumark said. They may be able to contribute up to 20 percent of their earnings, with a maximum contribution of $49,000.

People who do not have an employer-provided retirement plan and who were under age 50 last Dec. 31 may put up to $5,000 into a deductible I.R.A.; the limit is $6,000 for those 50 and older. For a single person who has an employer-sponsored plan, I.R.A. deductibility begins phasing out if modified adjusted gross income is $56,000 or more and ends at $66,000. The limits for married couples, whether filing jointly or separately and whether one spouse or both have an employer plan, are available at irs.gov.

AMEND AS NEEDED It still isn’t too late to correct mistakes you have made in the last three years — like paying taxes twice on those reinvested dividends — said Sidney Kess, a certified public accountant and tax lawyer with the New York law firm Kostelanetz & Fink.

Many people sold holdings in 2007, he said, and the last day to amend those returns, if necessary, is April 18.

People who have already filed 2010 returns but would like to contribute to an I.R.A. could do so by April 18 and file an amended return for last year. Of course, you will want to decide which funds to hold in the I.R.A. Tax efficiency is not an issue for those sheltered accounts.