| Here are five simple steps you can take to "tax-manage" your investment portfolio: - Buy individual stocks. By choosing whether to sell them in any given year, you control your potential tax liability. If you haven't taken a profit, there's nothing for the IRS to tax. Remember: the capital gains tax is not a tax on capital gains. It's a tax on transactions. (This is why Warren Buffett says his favorite holding period is "forever.")
- Minimize turnover. Taking short-term capital gains means subjecting yourself to short-term capital gains taxes as high as 37% (depending on your tax bracket) - plus possible state income taxes as well. If possible, hold winners for at least a year, if possible, to qualify for a preferential tax rate. Long-term capital gains taxes run from 0% to 20%. (Although high income earners may be subject to an additional 3.8% tax on both long- and short-term capital gains.)
- Offset your gains whenever possible. The IRS allows you to offset all realized gains with realized losses. And you can take up to $3,000 in additional losses against earned income. No one likes to take a loss, but occasional ones are a fact of life for every investor. The tax benefits make them less painful.
- Use your IRA, pension, 401(k) or other tax-deferred account to do your short-term trading since all profits will compound tax-deferred. Also, use these accounts to hold taxable bonds and real estate investment trusts (REITs) since these are high-income payers that don't qualify for the favorable tax treatment that U.S. corporate dividends receive.
- Own index funds rather than actively managed funds. Index funds tend to be highly tax-efficient because changes to an index are rare. Managed funds, on the other hand, often have high turnover and Federal law requires them to distribute at least 98% of realized capital gains to shareholders each year. You can get hit with a big capital gains distribution even when you haven't sold a share. And that's true even if the fund is down for the year. That hurts on April 15.
Take these steps and you'll lessen the government's annual tax bite on your portfolio, increasing your long-term returns substantially. The few remaining choices are simple ones like owning tax-free rather than taxable bonds if you reside in the upper tax brackets. In short, be aware of the tax implications of all your investment moves. Taxes shouldn't be your first consideration. But they are an important one. Whenever I write on this topic, I invariably hear from a few folks who tell me that avoiding taxes is un-American or unpatriotic. Baloney. The provisions that exist in the tax code were put there to encourage Americans to save, invest, own a home and take risks. So tax-manage your portfolio with a clear conscience. As Judge Learned Hand, who served for years as Chief Judge of the U.S. Court of Appeals for the Second Circuit, famously wrote... Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the courts have said that there is nothing sinister in so arranging ones affairs as to keep taxes as low as possible. Everyone does so, rich and poor; and all do right, for nobody owes any public duty to pay more than the law demands. Amen, Judge. Good investing, Alex | 
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