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With April 15th right around the corner, millions of last-minute tax filers will be scrambling to complete their 1040 form over the next couple weeks. By that point, nearly every taxpayer will know whether they have to cut a check to Uncle Sam, or whether they can expect to receive a nice refund. In either case, there's a good possibility that you could have been sitting even better -- with either a narrower tax liability or a fatter refund. I'm not referring to any obscure deductions you may have missed. Instead, take just a few minutes to skim back over Schedules "B" and "D" one more time. Quite possibly, you may have reported hundreds or thousands of dollars in dividend payments, income and capital gains on those pages -- and the government will be expecting a cut of the proceeds. Are You Giving Money Away? It may be hard to believe, but it wasn't that long ago that dividend distributions were taxed twice: once at the corporate level and then again at the individual level (at marginal rates of up to 38.6%). That all changed in 2003, when legislation was enacted that reduced the tax on dividends to just 15%. However, when it comes to the IRS things are seldom cut-and-dried, as there are numerous securities that fail to qualify for the favorable tax treatment, including distributions made by REITs, partnerships, many foreign stocks, and interest income generated by bonds and other fixed-income instruments. Therefore, the distributions made by most income-oriented funds -- which typically invest in a broad mixture of stocks, bonds, convertibles, preferred shares, and other income producing securities -- aren't fully entitled to the tax break. If an investor receives distributions totaling $3.00 per share from an income fund, it's a safe bet that they might wind up with as little as $1.95 (assuming an income tax rate of 35%) or so in their pocket -- and possibly less depending on state and/or local taxes. Assuming a net asset value (NAV) of $30.00, the same fund above would have a hefty pre-tax yield of 10% ($3.00/$30.00). But once the government has taken its share, the after-tax payout would be reduced to just 6.5%. In that case, the annual after-tax income generated from a $50,000 investment would drop from $5,000 to just $3,250 -- and keep in mind, that lost $1,750 would have accrued compound interest of its own. In fact, a $50,000 investment earning 10% would be worth $129,700 after ten years, versus just $93,900 for one earning 6.5% -- a tax burden of more than $35,000. However, as you'll see below, shifting that income into a tax-advantaged fund (reducing the 35% tax rate to 15%) could put nearly $20,000 of that amount back in your pocket. Tax Efficiency isn't just for Income Investors Fortunately, there are ways to reduce that tax bill -- while still giving Uncle Sam his due. Naturally, the first option would be to shelter the income inside an IRA or other tax-deferred vehicle. However, for the purposes of today's article, we'll assume you've already taken full advantage of any retirement plans and are looking to protect other assets from tax erosion. In that case, the closed-end fund world has launched an entire wave of new offerings designed to meet one investment mandate: seek out and profit from only those securities that qualify for the reduced 15% rate. These "tax-advantaged" funds can go a long way toward minimizing the tax liability that will be tallied up on your Schedule "B." But what about Schedule "D," where you recognize all the realized short and long-term capital gains? That growth fund won't typically throw off much in the way of dividends or income; however, in the process of buying and selling individual stocks, it will likely churn up some capital gains, and those can also lead to a large tax bite -- even if you don't sell your shares. For example, consider the AIM Global Equity "A" Fund (GTNDX), which has ridden stocks like Nokia (NYSE: NOK) and ExxonMobil (NYSE: XOM) to a hefty +16.5% annualized return over the past five years. While that figure looks great on paper, it loses some luster when you consider that the fund's managers have been trading frenetically. They haven't actually netted anything close to the return quoted above. In fact, a shareholder in the highest tax bracket would have only seen after-tax gains of +10.7% over the five-year period -- forfeiting more than $24,000, assuming an initial investment of $50,000. Fortunately, just as there are a multitude of closed-end funds (CEFs) designed to cut down on needless dividend taxes, exchange-traded funds can be equally useful in minimizing capital gains taxes. Important Note: In the remainder of this article, ETF Authority editor Nathan Slaughter provides in-depth profiles of his two favorite tax-advantaged funds. Both of which invest in foreign markets and provide total returns in excess of +25%, but each is taxed at just the 15% rate, allowing you to pocket most of those gains. However, in order to view the remainder of this article, you'll need to subscribe to our premium income-investing newsletter -- The ETF Authority. After you subscribe, you'll receive immediate access to this full article, as well as our monthly The ETF Authority newsletter and a host of additional premium content. Please visit one of the following links to continue. Good investing!
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