Tax-Efficient Investing Can Reduce Tax Bite

Tax-Efficient Investing Can Reduce Tax Bite

UNIVERSITY PARK, PA--Tax strategies can sometimes be even more complex than investment strategies, but failing to consider tax implications can seriously undermine overall returns in certain situations.

"Investors often overlook the tax bite associated with their investment portfolio, but that bite can be reduced with some tax-efficient investment strategies. Without proper planning, April 15th can bring unpleasant tax surprises of one sort or another," says Dennis Sheehan, professor of finance in Penn State's Smeal College of Business.

He recently co-authored a white paper on the topic, "Taxes and Your Investments: Tax-Efficient Investing Can Make A Difference." He co-authored the paper with Lisa Gray, an investment management professional who has held positions at PaineWebber, Morgan Keegan and Company, Sovereign Wealth Management, Inc., and Union Planters Investment Bankers Group. The Money Management Institute (MMI) -- the national organization for the $400-billion managed account industry -- sponsored the white paper.

"In simplest terms, tax-efficient investment strategies take into account the potential tax liability associated with various investment transactions in considering overall returns," explains Sheehan. " By contrast, most performance measures in the financial sector are reports on financial returns before any tax liability considerations, even though those tax liabilities accrue simultaneously with many investment transactions. Tax-efficient strategies put the spotlight on the after-tax return."

Since investment returns are realized at transaction time, investors may overlook these "tax costs" in their investment reviews and performance checks. In addition, the average investor's financial advisor may be separate and distinct from his/her tax advisor, making a coordinated approach difficult.

"Many investors are aware that taxes play an important role in their investment transactions, but surveys show that most do not consider themselves very knowledgeable regarding the tax implications of investing. Investors who ignore tax consequences risk diminished overall returns," says Sheehan.

He notes that there are strategies that may be used toward the end of any tax year to reduce tax liability, including tax swaps, paying attention to wash sale rules, and realizing losses specifically for tax purposes on poorly performing assets.

"Now is the time for consultants and their investor/clients to make decisions and employ specific investment strategies to protect portfolio gains from the erosive effects of taxes for the 2001 tax year. Part of an investment management consultant's role is to monitor and be aware of such situations so that appropriate action may be taken within the guidelines of the investment policy statement, which is based on the client's entire financial scenario."

He cautions that while it is prudent for most investors to be aware of the potential tax consequences of their investment activities, one should never base investment strategy solely on tax considerations.

"Taking a tax-efficient approach to investing may aid investors in influencing the size and timing of tax consequences associated with portfolio transactions. Investors should note that tax-efficient investing is really about maintaining control over tax liabilities," says Sheehan.