Tame Taxes in Your Taxable Account

Taxable accounts are appealing for the flexibility they offer, and they make a lot of sense for short-term savings and as a location for additional investments beyond contributions to tax-sheltered accounts. The obvious drawback, of course, is that your earnings are subject to taxes. Don't throw in the towel just yet, though. You can employ a few strategies to keep as much money in your pockets as possible.

Avoid Short-Term Gains
The simplest way to avoid losing unnecessary cash to taxes is to avoid short-term gains as much as possible. If you hold a security for a least a year before selling, your gains qualify for a reduced, long-term capital gains tax rate. Gains realized within a year of the purchase date are taxed as regular income, while the tax rate for long-term capital gains is only 15% for most investors. From 2008 until 2010, taxpayers in the bottom two income brackets do not owe any taxes on long-term capital gains.

Holding onto an investment for at least a year substantially increases your aftertax return. If you do a lot of short-term trading, on the other hand, a big chunk of your gains will go to Uncle Sam.

Pick Tax-Efficient Investments
Carefully selecting investments can also help reduce your tax hit from investments within your taxable accounts.

Mutual Funds
Unlike stocks, you could be liable for taxes on your mutual funds even if you have not sold them for a gain. Mutual fund holders must pay taxes on all fund distributions, including capital gains that occur whenever a manager sells an underlying holding for more than its purchase price, so it's important to evaluate funds' tax efficiencies before purchasing them. Morningstar mutual fund analyst Katie Rushkewicz outlines key data points to check in this article, including turnover ratio, tax-adjusted return, and tax-cost ratio.

ETFs
Studies have shown exchange-traded funds can be very tax-efficient over time, but tax benefits vary from ETF to ETF. The fact that most ETFs track indexes partially explains their tax efficiency--trading is kept to a minimum, and gains that are realized frequently qualify as long-term gains.

Furthermore, ETFs are shielded from having to sell underlying holdings to meet redemptions because most trading takes place between shareholders. Still, some ETFs, such as those that track indexes with a large amount of turnover, are not good tax bets.

As with funds, you can look at an ETF's tax-adjusted return and tax-cost ratio to get a sense of its tax exposure. Click here to learn more about ETFs and taxes.

REITs and MLPs
There are special tax considerations if you own real estate investment trusts or master limited partnerships, neither of which pay federal income taxes. REIT dividends are taxed as ordinary income, so it makes sense to save REITs for tax-advantaged accounts. MLPs are taxed in a unique way, and generally should be held in a taxable rather than tax-sheltered account. MLPs are not taxed at the corporate level. Instead, a proportional share of income is taxed at the individual level. This is why partners (as owners of MLPs are called) receive a special tax form (K-1), which breaks down the income attributable to you. This income is taxed at your marginal tax rate, not at the qualified dividend rate. Morningstar dividend expert Josh Peters explains the nitty-gritty tax details of REITs and MLPs in this video.

Employ Tax-Loss Harvesting
Inevitably, your portfolio will include some disappointing performers. No one enjoys realizing a loss, but holdings that seem unlikely to recover in the future can at least help you offset taxes. The loss offsets your taxable gains or, if you do not have any gains, allows you to reduce your taxable income by up to $3,000 each year. If your loss was greater than $3,000, the exceeding amount carries over to the next tax year. A big loss can shield against taxes for several years. 

An important restriction to keep in mind if you sell for a loss is something called the wash-sale rule, which prevents you from claiming a loss on a security if you buy a substantially similar holding within 30 days of the sale. You can generally repurchase the same holding after 31 days, but it's a good idea to check with a tax advisor if your situation is complex.

This article has been corrected since its original publication. For details, click here.