Dont Let Taxes Control Investment Decisions

Taxes can eat away a significant portion of an investment's return. Yet at the same time, financial planners caution against allowing the "tax tail to wag the investment dog."

Investment decisions should be based first on the economics of the investment — its risk, the likely direction of its future returns, and whether it fits your current investment plan. Taxes usually should be a secondary consideration.

Nonetheless, numerous tax strategies can reduce the tax bite on your investment returns without compromising the investment itself.

Know the cost basis of your investment. Cost basis is essentially the cost of buying or taking ownership of an investment. An accurate basis is needed when determining an investment's gain or loss from its sale in order to calculate the size of the tax liability (or deduction). Failure to adjust cost basis for such factors as fees or commissions paid when buying the investment, stock splits, or inheriting the investment could lead to a higher tax bite than necessary.

Don't forget reinvested profits. When calculating their cost basis after selling mutual fund shares, investors often neglect to include reinvested dividends or capital gains. In taxable accounts, those dividends and gains are taxed annually, even if reinvested in the same fund. Shareholders who fail to include them in their basis end up paying taxes twice on those capital gains and dividends. The same principle can apply to some discounted bonds, earned/paid dividends and interest on individual securities and investments.

Keep an eye on mutual fund tax efficiency. Some mutual funds, or types of mutual funds, are more "tax efficient" for their investors than other funds by activly matching gains and losses within the fund to minimize annual tax liabilities.

Know when you bought your investment. Holding an investment for longer than a year provides substantial tax breaks — as long as holding it that long is worth the investment risk.

Offset capital gains and losses. You can offset gains from the sale of investments with corresponding sales of losing investments, or vice versa.

Choose tax-favored investments and strategies. You can minimize, delay, or even eliminate investment taxes through such vehicles as retirement accounts, annuities, municipal bonds, life insurance, or "like-kind" real estate exchanges.

Employ certain estate planning techniques. Tried-and-true techniques such as annual tax-free gifting or the gifting of appreciated assets can save substantial estate and income taxes.