Another financial instrument which is getting popular when it comes to saving taxes in the current low interest rate regime is master limited partnerships (MLPs). These instruments have also become popular because of the higher yield in comparison to other instruments like treasury bonds, bank CDs, or money-market accounts. MLP’s can operate at a loss particularly in the first few years particularly in industries like developing oil and gas pipelines due to high depreciation and hence reduced net earnings.  However after the initial phase MLP’s will in probability generate free cash flow in excess of earnings on which taxes are not levied until the owner sells the unit as it is treated as a return on capital. Approximately 80% of MLP distributions are labelled as return on capital.

High yields on MLP’s is another factor that makes this an important tax deterring instrument. Yields on pipeline MLP’s is as high as 7% to 8% in comparison to yields on around 2% to 4% yield on real estate investment trust which is also very popular when it comes to saving taxes. Also the yield on MLP’s have more than doubled in the past one year. Yield spreads on MLPs in comparison to the 10-year Treasury note has more than doubled to approximately 5.75% in 2009 from 2% in 2008. Also MLP’s have experienced less market volatility in comparison to the 10-year note.

The main tax benefit of owning an MLP is that though the entire annual distribution is received tax payment on the same is deferred to the extent it is classified as return on capital. For instance if an investor’s total annual distribution is say $2 per unit of which 80% is classified as return on capital, which is deferred, then his tax payment is  only on 40¢ of each unit’s income. These distributions are taxed like ordinary income on which normal income tax is levied. Also tax experts feel that by deferring the taxes to the future and by holding the unit for a long time you would end up in the lower tax bracket and hence be taxed lower.

Also if you are looking for investing in fixed income market minus the low yields or interest rate risk associated with treasury bonds then MLPs are the right instrument for you. However stock performance of these partnerships is correlated to the return on the 10-year Treasury bond.

One main problem with MLP’s is that under the US tax code any net loss that results when they are sold is taken to be inert and hence cannot be used to compensate for income from other sources. Accounting wise this loss has to be taken forward and netted off only against future income from the same partnership.

Ofcourse the performance of MLP’s is dependent on the sector they are investing. For instance MLPs that are involved in building natural gas and oil pipelines or storage facilities are considered to be better than MLP’s that invest in oil or gas production as pipeline and storage capacity are let out at fixed rates through long-term contracts and hence generate cash irrespective of the change in energy prices. MLP’s that invest in energy production are exposed to fluctuation in energy prices and hence rise or fall according to oil or gas prices. When energy prices increase energy MLP yields increase and vice versa.

In addition to the above discussed financial instruments, dividend paying stocks are also good investment options when it comes to saving taxes as the income stream from the same is taxed at the dividend rate of 15% which is the equivalent to capital gains rate.

Last but not the least the most important rule for investors looking to save taxes is to keep their eyes and ears open for developments in order to maximise return and save taxes. In all probability in 2011 tax rates on both dividends and capital gains are likely to increase and return to the pre Bush tax cuts. With this the whole financial environment will change and the current options for tax saving may become redundant.

Read more at: Tips For Investors Looking To Save Taxes- Part I

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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.

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