Using your tax return to bolster your investment strategy

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Want to boost your investment performance? The key to better returns could be lurking in your tax return.

I just finished my federal and state taxes, a baffling array of bizarre calculations and financial minutiae that ran to 31 pages. And, like everybody else, my instinct is to stuff my copy into the basement filing cabinet, hoping never to see it again.

But that would be a mistake. Here's how to use your 1040 to check on your investment strategy and bolster your results.

-- Finding trouble. Thanks to the 2003 tax law, long-term capital gains and qualified dividends are taxed at a maximum federal rate of just 15 percent. But is your portfolio structured to take full advantage of this?

To find out, grab your federal tax return. See if Schedule D lists substantial short-term capital gains. Check how much taxable interest is listed on your 1040's line 8a. And, by looking at lines 9a and 9b, calculate what portion of your dividends aren't qualified.

"Those are the three things I immediately look at," says Pittsburgh accountant and attorney James Lange. "If those three are high, maybe you're missing some opportunities" -- and it's time to revamp your portfolio.

What's wrong with short-term capital gains, taxable interest and dividends that aren't qualified? Unlike long-term capital gains and qualified dividends, these investment earnings aren't taxed at a maximum 15 percent. Instead, they are dunned at ordinary income-tax rates, and that means paying as much as 35 percent to Uncle Sam.

-- Taking shelter. Which investments create such horrendous tax bills -- and which don't? Consider two extremes.

Let's say you own an actively managed stock fund that invests in real-estate investment trusts. REIT dividends typically don't qualify for the 15 percent rate, because REITs already get a special tax break at the corporate level.

To make matters worse, your REIT fund manager may sell winners within a year of purchase, thus generating short-term capital gains. Result: Your REIT fund will be horribly tax-inefficient -- and you would want to hold it in a tax-sheltered retirement account.

For comparison, suppose you also own U.S. stock-index funds that track market averages like the Standard & Poor's 500 or the Dow Jones Wilshire 5000. Because such funds do scant trading, they will generate relatively modest annual distributions. And those distributions you do receive should be mostly long-term capital gains and qualified dividends, both eligible for the 15 percent rate.

"If you have high-returning, tax-inefficient asset classes like REITs, high-yield junk bonds and actively managed stock funds, those should be in your retirement account," says Glenn Frank, a financial planner with Wachovia Wealth Management in Waltham, Mass. "Meanwhile, in your taxable account, the no-brainer is tax-efficient stock funds," such as tax-managed funds, index mutual funds and exchange-traded index funds.

-- Growing interest. You also need to find a home for your high-quality bonds. To that end, imagine you are considering corporate bonds that pay 6 percent, municipal bonds from your own state that yield 4.5 percent or paying down your 6 percent mortgage.

Faced with that choice, you would probably want to purchase the 6 percent corporates in a retirement account. That way, you would earn a healthy yield while deferring taxes on the interest. You would likely also get other benefits. For instance, if you fund a 401(k) plan, you would get an initial tax deduction and maybe a matching employer contribution.

Problem is, you may have already filled up your retirement accounts with REITs, junk and actively managed stock funds -- and thus you're looking at buying bonds in your taxable account. Next step: Collect two vital pieces of information.

First, with your 1040 at your side, head to and use the marginal-tax calculator, which will help you figure out your marginal federal-tax rate. Let's say it is 28 percent. Add in state taxes, and your marginal rate might be 32 percent.

Second, look at line 40 of your 1040, where you list your standard or itemized deduction. If you live in a high-tax state or you are in the early years of your mortgage, your itemized deduction is likely well above the standard deduction.

If that's the case, you wouldn't want to make extra-principal payments on your 6 percent mortgage, because the true cost is just 4.32 percent, after figuring in the federal-tax deduction and assuming no state-tax deduction. You also wouldn't want to buy the 6 percent corporate bonds in your taxable account, because the yield would be 4.08 percent after paying federal and state taxes. Instead, your best bet would likely be the 4.5 percent munis.

On the other hand, when you look at your 1040, you may discover you're taking the standard deduction or that your itemized deduction is barely above your standard deduction. For 2006, the standard deduction is $10,300 if you are married filing jointly and $5,150 if you are single.

In that scenario, your best "bond" investment may be paying down your mortgage, says William Reichenstein, an investments professor at Baylor University in Waco, Tex.

"If the combination of your home-mortgage interest, your charitable contributions and your other deductions is less than your standard deduction, you aren't getting any tax benefit from your mortgage," Prof. Reichenstein notes. "That means your 6 percent mortgage is costing you the full 6 percent and you might want to pay it off. You can't get a guaranteed 6 percent after-tax return on a bond."

What Goes Where

To trim your tax bill, carefully divvy up your investments.

Best for retirement accounts: Actively managed stock funds, real-estate investment trusts, high-yield junk bonds, stocks you plan to trade, high- quality corporate bonds.

Best for taxable accounts: Index mutual funds, exchange- traded index funds, municipal bonds, stocks you plan to hold, tax-managed funds.


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