Don't Mess With Taxes

Welcome to Chapters 10 and 11 of "The Bogleheads' Guide to Investing" consolidated book review. If you missed my earlier announcement of the project, you can find details on it here.

As you've probably already guessed, these two chapters deal with taxes. A fitting topic for Friday the 13th.

For many people investing itself is scary. Tax considerations just compound that fear. It's not an unreasonable reaction, but the Bogleheads do a very nice job of helping ease such trepidation.

Naturally, the topic of investment taxation could itself fill a book. So authors Taylor Larimore, Mel Lindauer and Michael LeBoeuf wisely opt for an overview to familiarize readers with two important tax concepts.

Chapter 10, Taxes: Part One, looks at mutual fund taxation. Chapter 11, Taxes: Part Two, examines how to manage your portfolio for maximum tax efficiency.

Chapter 10 -- Mutual Fund Taxation: Messrs. Larimore, Lindauer and LeBoeuf cut right to the chase as to why it's critical for investors to understand the tax implications of their fund investments. Numerous studies show that over the long term, a fund can lose almost a quarter of its returns to taxes. In order to reduce such a real-dollar cost, you must first understand how taxes are applied to investments.

This chapter breaks out the various fund earning components and the applicable taxes on dividends and capital gains. Tax law changes in the last few years have lowered the tax rates in these area, a welcome development for investors. But, as is usually the case when it comes to taxes, it's not that simple.

For example, specific requirements must be met in order for earnings to receive these lower rates. In the case of stock dividends, they must be IRS qualified dividends; not all are (and, as the authors note, no bond dividends meet the lower-rate guidelines). So it's critical to fully understand how your fund pays earnings and just how much, or little, of those earnings are eligible for lower tax rates.

Chapter 10 offers helpful examples of each tax situation and how savvy fund managers can help reduce taxes. Particularly helpful are the tips on how to identify funds that are managed most tax-efficiently.

I was particularly pleased to see this chapter also places tax responsibility on individual investors. While we might not have explicit control over a fund's returns, write the authors, we can control many investment costs, including taxes. And they lay out specific steps to consider when investing in taxable funds, such as the importance of buying and holding, properly timing necessary sales and purchases around a fund's distribution date and harvesting tax losses.

Of course, one optimal way to lower taxes is to invest in tax-sheltered accounts. This is the focus of the Bogleheads' second tax chapter.

Chapter 11 -- Managing Your Portfolio for Maximum Tax Efficiency: "We think the best way for most investors to minimize taxes is to take advantage of IRS tax-favored retirement plans … ."

This Bogleheads' recommendation is the path taken by a great many investors, particularly those with relatively limited amounts to commit or who are more hesitant in their investment approaches. They will find this chapter especially useful, but it's also one that even more sophisticated investors should read.

In addition to pointing out the many advantages of tax-favored retirement plans (401(k)s and the similar plans for public employees, as well as the various IRA options), here we also are presented the disadvantages and tax implications of each of these savings vehicles.

Take a 401(k), for example. As old-style pension plans have essentially disappeared, most workers rely on these accounts to prepare for eventual retirement. But ill-informed or uninformed choices can make a big difference in how comfortable those post-work years will be.

Chapter 11 pays particular attention to the high price that fees can exact on a 401(k) plan, offering readers tips on ferreting out these expenses and options for dealing with the costs.

Similarly, Chapter 11 gives us a well-designed look at the differences, both from the investment and tax perspectives, of the various individual retirement accounts and tips on how to determine which account is best for your personal financial circumstances.

In each tax chapter, the Bogleheads make good use of examples, both in text and tables, and bullet-point lists (one of my personal favorite illustrative devices) to drive home their advice. The approach makes the 23 pages on investment taxes easy reading and, more importantly, gives the investor clear and practical steps to put into action to fulfill the two chapters' ultimate goal: maximum total returns after taxes.

If you missed any of the previous chapter reviews by my fellow personal finance bloggers, you can find links to them at this All Financial Matters page, where you'll also get a preview of upcoming chapters.