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Sidestep Unpleasant Tax Surprises in Your Portfolio

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. It's Tax-Wise Investing Week on Morningstar.com, and today we're talking about ways that investors can be proactive and avoid unpleasant tax surprises in their portfolios.

Here with me to offer some tips is Morningstar's Christine Benz, director of personal Finance.

Christine, thanks for joining me.

Christine Benz: Jason, great to be here.

Stipp: So, you gave me a few unpleasant surprises that investors might encounter in their portfolio. The first one has to do with a very hot topic around here, dividends, and especially, foreign dividends. We know that investors are now roving the globe trying to find income-payers, but from a tax perspective, there are few things to keep in mind if you're looking overseas for your dividends.

Benz: That's true, Jason. You're right--in some cases foreign stock dividends are higher than what you might get from comparable companies here in the U.S., so the attraction is there.

The potential pitfall is that if those dividends from foreign stocks don't count as qualified dividends, they may be taxable at your ordinary income tax rate. They wouldn't be subject to the currently favorable 15% tax, but rather your ordinary income tax, which is going to be much higher, in some cases twice as high, as what you might pay for dividends.

Stipp: So, we know that foreign dividends are one thing to keep on your radar, but we also know that longer term, we might see different treatments for all dividends. It's something that will expire if Congress doesn't take action. What should you be thinking about there [with respect to] the kinds of the investments that you are holding?

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Benz: Well, it's a really good point, Jason, and I would urge anyone to take a step back and not make any pre-emptive changes, because Congress could change its mind, but right now, the current dividend tax treatment is set to expire at the end of 2012, which would mean that in 2013, your dividends would be taxed at your ordinary income tax rate.

I think that has some implications for asset location. So, to the extent that you've been holding dividend-payers in your taxable accounts, you may want to think about an exit strategy for getting them out of there. The key thing you need to keep on your radar, though, is that if they have appreciated in price since you purchased them, you could be on the hook for capital gains taxes, even as you are trying to reduce your dividend taxes. So, it could require some fancy footwork, and by all means, don't make any changes pre-emptively, because I think we could see dividend stay on and even playing field with capital gains; we just don't know at this time.

Stipp: Important to know that it is potentially there. At least, assess your situation and know what that could mean should it come to pass.

Another kind of investment, Christine, that we do see are these enhanced index funds. Normally you'd think of an index fund as being pretty tax efficient, but what's the story with these enhanced index funds? What are they doing and why might that be a tax consideration?

Benz: There are a variety of strategies that these funds use. Not all of them are necessarily tax inefficient, but I would point to funds like PIMCO StocksPLUS as an example of a fund that uses derivatives to obtain basic stock market exposure, and then it invests in bonds on the side in an effort to enhance the fund's overall return.

The funds have had mixed results to-date, some of had good performance in certain market environments. The key thing to keep in mind is that that bond piece means that they're not pure equity; they actually have a bond component, and the return piece from that component of the portfolio is going to be taxed, again, at your ordinary income tax rate.

So, be mindful if you are looking at funds like that. Hold them in your tax-sheltered accounts. They are by no means as tax efficient as a plain-vanilla S&P 500 Index tracker.

Stipp: Something else that investors really should do is look underneath the hood of their funds and see the activity that the managers are undertaking. That can also generate a certain tax liability. What should be on your radar there?

Benz: If your fund does a lot of frequent short-term trading, it could trigger short-term capital gains taxes, and if your fund or if you personally are generating short-term capital gains, you will have to pay ordinary income tax rates on those gains.

So, take a look at what the fund is doing. You can use turnover as a rough proxy for how frequently the manager is trading, but ideally dig in and look at specifically what types of gains the fund is generating. We've got some nice tools on the site to help you look at how tax efficient a fund has been in the past, so you are able to see, relative to its peers and in absolute terms, how much of the fund's gains have gone to pay taxes.

Stipp: Another thing that should be on investors' radars is actually in a space you wouldn't expect, which is muni bonds, which normally will keep you from having to pay especially those federal taxes and in some cases state taxes, too. But there's something else you should keep in mind about these muni funds. What is that?

Benz: Well, some of the funds hold what are called private activity bonds, and these bonds are subject to the alternative minimum tax. So, most muni income is not subject to the AMT; the income from these private activity bonds is. So you want to pay attention to what your funds have, and if you are a person who is potentially subject to the AMT, and this is a growing group unfortunately, really be careful of some of these funds that are deriving a lot of their income from private activity bonds, because that could enhance your susceptibility to the AMT.

Stipp: Lastly, Christine, another investment type that's very hot among our readers right now, MLPs. These tend to throw off a lot of income. They are very attractive, especially in the current environment, to a lot of folks. But they come with their own set of special tax considerations. What are those?

Benz: Well, they do, and most people assume that if something kicks off a lot of income, as MLPs do, you want to hold them inside of an IRA or some other tax-sheltered wrapper. But actually, you want to hold [MLPs] in a taxable account. The reason is that if a portion of a distribution that an MLP makes counts as what's called "unrelated business taxable income," and that amount exceeds $1,000, it will be taxable, and you will have to pay taxes on it even before you withdraw your assets in retirement. So, that's something that you want to avoid. In most cases, people will want to keep their MLPs inside of a taxable account, and they will tend to be quite tax efficient when held there.

Stipp: All right, Christine. Thanks for helping us avoid these potential tax pitfalls in our portfolio and for joining me today.

Christine Benz: Thank you, Jason.

Jason Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.