Tips For Investors Looking To Save Taxes- Part I

The times are definitely hard and in these hard times taxes can be a big drain on one’s pocket. One easy and very effective way to save on taxes is by investing in tax saving instruments. But is it so simple. Not all investments will get you the same tax benefit. In fact I would like to modify my earlier statement and say that the best way to save on taxes is to invest judiciously.  For instance one way of reducing tax liability is to hold on to investments for longer period of time. You will in all probability be taxed higher if you sell off your investments earlier than its total life. However holding all investment assets for a long time will not help in saving taxes. It is important to understand which assets should be held for a longer period to get maximum tax benefits.

In short investors need to understand the methods of financial planning that will help them reduce their tax liability on gains in their portfolios. Below are few investment tips that will help in saving your taxes in building your portfolio for 2010.

Municipal Bonds

From a tax point of view the best investment any day are Municipal bonds as interest received on these bonds is tax-free. However there are still small technicalities in investing in municipal bonds that one needs to understand and keep in mind before investing. For instance if you invest in bonds that are used to finance nonessential services like tobacco, sports stadiums, and airline terminals then you would be subject to Alternative Minimum Tax (AMT).

However financial planners still consider municipal bonds to be the best instruments to beat the tax atleast for the next couple of years assuming that the current levels of capital-gains and ordinary income tax rate will continue. However in the current economic environment given the current high level of federal deficit, there are high chances that income tax rate may be increased in 2011 and president Obama has already hinted about increasing capital-gains taxes. Still municipal bonds score higher than treasury bonds as they provide a larger after tax returns due to higher yields. Municipal bonds are not however risk free like treasury bonds though the amount of risk is much lesser than most other assets.

Financial planners recommend municipal bonds for those who are looking at maximising their income. Also it is advisable to buy them only through a money manager like the American Century High Yield Muni Fund. Investing in municipal bonds requires research into the books of the municipality to understand the actual value of the bond and the risks involved. Fund managers with their credit research department are trained to do this research. It is very important to properly evaluate the fund and look into the technicalities before investing. There are many hidden risks involved which only a trained eye can bring to the forefront. For instance it is important to know the reason behind the bond paying premium yields to get an idea of the risk involved. The high premium could be to cover up risk of the issuer being a smaller entity or the bonds being an unrated or uninsured bond. These hidden elements carry their own risk which an investor needs to evaluate before putting their money in these assets.

Selecting the fund manager is again an important decision which will determine the course of financial future of your assets. I personally believe and advice to go in for fund managers who believe in preserving capital. I don’t prefer to go in for fund managers who take more risk and result in fluctuating returns in search of higher returns. But this decision is entirely a matter of individual preference and risk appetite.

It is also advisable to invest in funds that invest in municipalities that provide critical services like build sewers or run electric utility or the primary hospital rather than those that are involved in non essential services like building a stadium. No doubt the latter will provide higher yields but then these higher yields are also associated with higher risk.

Normally at year end one can get municipal bonds at good discounts as people who are holding closed end municipal funds would sell funds that have had losses irrespective of their value so that they can compensate for gains in other parts of their portfolios. This year the discount however is much lesser at just 5% to 7% as against a discount of 25% last year mainly on account of increased demand for municipal funds which due to current low interest rate regime has resulted in higher dividend payouts this year.