How You Can Save Taxes on Your Investments

It’s March Madness time, but not all the craziness is happening on college basketball courts.

Investors are also running around, searching for ways to reduce their tax burdens before the April 15 deadline. Although it’s generally too late to make changes for the 1991 tax year, this may be an appropriate time to map out a mutual fund tax strategy. Here are some tips to consider:

* Put money into an individual retirement plan.

If you haven’t contributed to an IRA for the 1991 tax year, you have until April 15 to do so. If you’re not covered by a pension plan at work, you can deduct the amount you invest, up to $2,000 a year. Even if you participate in a company plan, you might get a partial IRA write-off, depending on your income level.

Whether you get a deduction or not, your IRA earnings will grow free of taxes until you withdraw the money, making this a nice way to build up wealth. It’s also a good way to simplify your life from a tax perspective, since you don’t have to keep track of capital gains, losses or dividend income on your mutual fund investments.

* Consider municipal bond funds for tax-free interest income.

Although yields on muni portfolios have dropped to the 6% range, that’s still three percentage points above the inflation rate. Historically, muni funds have had “real” or after-inflation yields averaging about 2.5%, says Todd Curtis, portfolio manager of the Tax-Free Trust of Arizona. “The current real return beats the historic norm by half a percent,” he says.

Keep in mind, however, that only the dividend interest on muni funds avoids taxes. If the share price changes between the time you buy and sell, you will incur a taxable gain or loss.

* Pay attention to distribution dates.

All mutual funds pass dividends and capital gains or losses on to their shareholders each year. Unless you hold the fund in an IRA or other sheltered account, you would owe taxes on the distributions.

Eventually, when you sell shares, you can reduce your taxable profit by the amount of taxes paid along the way. But if you buy and hold long term, you might not recoup the costs for many years.

One way to minimize this problem is to delay investing until after a fund declares a distribution (the actual payment date may be weeks later). You can usually find out about the declaration date by calling the fund company. Most stock funds make distributions in December, so people should be careful about investing at that time, says Ken Gregory of L/G No-Load Fund Analyst, a San Francisco-based newsletter.

Bond funds typically have smaller distributions--and they declare them on a monthly basis--so it’s less worthwhile to try to avoid these payments.

On a related note, Gregory says, it’s pretty tough to find “tax-efficient” funds--those that pay lower annual distributions either because they avoid high-yielding securities or because they hang onto their holdings longer, triggering fewer taxable transactions.

In a study of the pretax and after-tax returns of 37 top funds, Gregory determined that the most efficient funds delivered up to 0.6% a year more than the least-efficient portfolios. But he concluded that it’s too hard to identify these efficient funds, adding that investors would do better simply to avoid buying shares prior to a distribution.

* Review the tax implications before selling.

The IRS offers three ways to calculate capital gains and losses. If you unload all your shares in one transaction, it doesn’t matter which method you use--your taxable gain or loss would be the difference between the purchase and sale amounts, adjusted for any capital gains or dividend distributions along the way.

But if you make a partial redemption, you have an opportunity to enjoy significant tax savings.

Unless you make a choice, the IRS will assume that you’re using the first-in, first-out, or FIFO, method. This means that the shares you sell will be deemed the ones you purchased first. The problem is that those shares may be the ones with the lowest purchase price, assuming that your fund has appreciated over time. So, FIFO would probably result in the largest gain on which to pay taxes.

A second method, average cost, assumes that all shares were purchased at the same price, calculated as the total amount you invested divided by your total number of shares. Some mutual fund companies now list the average cost on shareholder statements, although it’s not hard to calculate.

The third main method, specific identification, offers the greatest potential for tax savings. You can opt to sell your most expensive shares first--regardless of when purchased--to minimize your taxable gain. The key is to specify these shares at the time of the transaction--not later--so it’s a good idea to document your choice in a letter to the fund company.