Summary Introduction and series overview. What I put into my taxable accounts. What I put into my tax-deferred accounts. How I deal with foreign stock dividend withholding. Summary. Back to Part VI Introduction and Series Overview This series is meant to be an explanation of how I constructed my own portfolio. More importantly, it I hope to explain how I learned to invest over time, mostly through trial and error, learning from successes and failures. Each individual investor has different needs and a different level of risk tolerance. At 66, my tolerance is pretty low. The purpose of writing this series is to provide others with an example from which each one could, if they so choose, use as a guide to develop their own approach to investing. You may not choose to follow my methods but you may be able to understand how I developed mine and proceed from there. The first article in this series is worth the time to read based upon some of the many comments made by readers, as it provides what many would consider an overview of a unique approach to investing. Part II introduced readers to the questions that should be answered before determining assets to buy. I spent a good deal of that article explaining investing horizons, including an explanation of my own, to hopefully provoke readers to consider how they would answer those same questions. Once an individual or couple has determined the future needs for which they want to provide, he/she can quantify their goals. If the goals seem unreachable, then either the retirement age needs to be pushed further into the future or the goals need to become attainable. I then explained my approach to allocating between difference asset classes and summarized by listing my approximate percentage allocations as they currently stand in Parts III and III a. Part IV was an explanation of why I shy away from using ETFs and something akin to an anatomy of a flash crash. In Part V I explained the hardest lesson about investing that I have had to learn: why holding cash is not a bad thing at certain times. Part VI was an explanation of why and how I sell long-held positions. In this article I will address some of the decisions investors should consider that concern taxes on gains and dividends. I will admit that I am not an expert on taxes. Even though I am a CPA (retired), I was focused on the corporate side and financial statements. I avoided preparing taxes for anyone outside of family, so my experience in the area is more akin to that of an average investor. If readers have more advice or tips to include in the comment section, I encourage leaving comments to share sage advice with others. This is not intended to be a treatise on tax planning; rather some simple-to-follow advice that could help some investors avoid the occasional unnecessary tax bill or loss of irretrievable withheld taxes. What I put into my taxable accounts I start off with an investment I have absolutely no intention of selling ever, and that will have no capital gains: municipal bonds. These securities have long been a stalwart of retirees looking for federal tax-free income. These securities are also targeted by those in higher income brackets. Historically, municipal bonds have enjoyed a very low default rate averaging just 2.7 defaults per year from 1970-2009. During that 40-year span, only five general obligation [GO] bonds have defaulted amounting to only about seven percent of total municipal bond defaults. Most municipal bond defaults historically occurred in issues supporting healthcare and housing projects (73 percent of all defaults). How times have changed! Since the financial crisis, we need to do more homework on selecting municipal bonds. The total number of municipal bonds rated by Moody’s in 2011 was about 17,700. But, even then, the majority of municipal bonds were rated A3 or better by Moody’s. By the end of 2013, Moody’s was rating approximately 2,000 fewer municipal bond issues. The overall default rate has risen from .01 percent prior to 2007 to .03 percent since then; still a very low rate. But a trend is emerging according to Moody’s. Headlines have covered many of the concerns about major municipal bond defaults like Harrisburg, PA, Stockton, CA, Jefferson County, AL, and Detroit, MI. Puerto Rico is in trouble now and both Chicago and the State of Illinois are raising concerns in the headlines. I have some simple rules to avoid municipal bond defaults and I hope readers can add to my list in the comments. I avoid GO issues in cities, counties and states where the pensions are funded below 75 percent. Here is a list of states with underfunded pension plans from Bloomberg (as of December 31, 2013). Another site that appears to be more up-to-date and comprehensive (including funding by individual plan) can be found here . If you want to look up distressed pension plans of local governments you can easily “Google” (search) for what you want to know. I searched for Pennsylvania (because I know there are many problems in local pensions there) and got this link about 562 of the local municipality pension plans being underfunded by $7.7 billion. That equates to 46 percent of the locally administered pension plan in the state! This does not include all underfunded plan, just the ones considered in distress. The point is that we need to be very selective when buying GO bonds and do a little due diligence. I prefer revenue bonds backed by a sustainable stream of revenue such as a toll road or airport. But even then, I take a long, hard look at the financial history and projected financials to make sure that revenues have been covering debt service obligations fully after operating expenses as well as fully funding the required sinking fund for the eventual debt repayment. That information should be available in a prospectus for the issue. You should also be able to get research reports and a prospectus from your brokerage, usually online. I only buy municipal bonds rated “A3” (by Moody’s) or better and only when I can secure a yield of at least five percent per year to maturity. Those are my rules. Adjust them as you see fit to suit your needs or make your own. With all the talk about underfunding of public pensions and with the unspoken problem of underfunded post-retirement benefits (think health insurance) by many issuers of municipal bonds, I expect some more major defaults coming in the future. When a Chicago or State defaults on one or more issues we will see rates rise again giving the patient investor another opportunity to lock in above average rates. I do not plan on providing that much detail about each investment category in this article but felt that municipal bonds tend to get ignored so I thought it might be helpful to provide more information. I did not begin to buy municipal bonds until my early 60s as I began looking for solid yield with tax avoidance benefits. Next, I also hold some stocks in taxable accounts. It depends upon where I have cash available (taxable or tax-deferred accounts) and what type of equity I am buying as to which account I use for the purchase. This is important because you can let several percentage points slip away to taxes if you do not plan ahead. Foreign stocks will generally go into my taxable account so that I can get either a refund of withheld taxes or a tax credit on my tax return. It all depends on the bilateral agreement between the U.S. and the country where the company is based. I will get into this later on in the article.**** High quality domestic or foreign companies that tend to do better than the overall market in downturns and have a long history of increasing dividends with no dividend cuts can go in either account depending on where I have cash available. I do not worry so much about the capital gains tax on these holdings because I intend to keep them forever. Dividend income is taxed at a relatively low rate currently, but that could change. I tend to put more of these securities into my tax-deferred accounts because of the potential for the dividend and capital gains taxes to be increased in the future. One thing that most investors do not think about is that as long as one has some earned income he/she is usually able to contribute shares instead of cash to an IRA account (especially Roth IRA) each year. If the tax laws change and tax on dividends increases too much I plan on using this method to move some shares each year to tax-deferred accounts to lower my tax bill. For me, anything over a 20 percent tax rate on dividends will prompt some movement to my wife’s or my Roth IRA accounts. All rental real estate properties are held as taxable investments. One could put real estate into a Roth IRA, but the tax advantages are significant already without taking that step. The only time it can get expensive tax-wise is when one decides to sell a property. Well, it also gets somewhat expensive when the mortgage gets paid down and the property is fully depreciated, but there is a way around paying the taxes. Admittedly, I have not yet done this but one could enter into a like exchange to purchase another rental property of greater value and defer the capital gain. An example would be to trade a single family residential rental property for either a larger, more expensive single family property or for a multi-family property up to four units. More than four units may not be considered a like exchange, if I recall correctly when I was looking into this a few years ago. The value of exchange is limited to the equity in each property. If the equity held by each party is nearly equal, there would be little or no capital gain involved. One party is looking for current income while the other (buyer of the larger property) is looking for future income and, thus, more current leverage and tax deductions. This strategy is worthwhile for those who get started in real estate early in life and get to the point where too much positive income is being generated from a property. One can also trade one residential property for two or three single family residences, each with lower equity built up, so that the total of the equity on both sides of the trade is nearly equal. But this requires more time inspecting and verifying expenses for each property as well as more time to manage. But it is an option for those interested in sticking to single-family properties. Of course, I also hold all my precious metals in taxable form. It can be added to an IRA, but because there is no income, I do not choose to go that route. Finally, I also hold cash and VFIIX in both types of accounts. What I put into my tax-deferred accounts My tax-deferred account may hold some corporate bonds of companies that I expect to be around long after I am gone. Currently, I do not hold any bonds, corporate or government (other than VFIIX). When I do buy bonds (and I will again when interest rates are higher), I stick with investment grade bonds issued by companies that I know and understand. I prefer rates much higher than have been available since before 2008. My cut off is seven percent. I realize that such a high rate may seem crazy in the current interest rate environment, but that should explain why I do not have any right now. There is nothing available of quality anywhere near that rate at this time. Once again, I will be patient and pick up the bargains when availability improves. I do not expect that to occur unless there is a general financial crisis or inflation rears its head again. The reason I hold bonds, especially long-term bonds, in my tax-deferred accounts is that the income is taxed at my personal income tax rate. That rate is not very high currently, but I expect it to go up instead of down, so I am trying to do the prudent thing. When I was fully employed and earned an above average wage this was far more important. As to inflation relative to equity values, a little is good for stocks but too much is a killer. The same holds true for bonds. Sustained inflation above five percent will cause long-term interest rates to rise to levels where investors may be able to capture quality issues yielding eight percent or more. Locking in a long-term yield above eight percent is something which every investor needs to take advantage of. I do not expect such an environment for several more years here in the U.S. But I do believe we will see it again before too long as the deflationary pressures begin to lift as the millennial generation hits its earnings potential stride sometime in the mid-2020s. If I am still writing when the time comes, I will be sure to provide my viewpoint about when interest rates seem to be hitting a top. Basically, the Fed stops raising the discount rate and inflation begins to taper slightly when the top has been reached. I may not get the top but I will definitely be loading up shortly after it has been achieved. Even if rates go a little higher, I will refrain from crying tears of regret as I will have my eight percent or more each year to console me. Treasuries fit the same profile as corporate bonds but I prefer corporate bonds over Treasury bonds for the higher yield, assuming the relationship remains in the future. I doubt that we will see another period like the one we had in the 80s when 30-year Treasury bonds hit 15 percent. But with all the debt around, who knows? If Treasuries were to get near that level again, I would need to reconsider and weigh the options. Foreign sovereign bonds are an asset I would only hold in my tax-deferred account. The reason is two-fold: while I might be giving up some withholding of interest in some cases, the relative currency values [FX] and current income tax issue outweigh that consideration, in my opinion. Of course, I would want to do my due diligence on the withholding issue to make sure I was not stepping into something egregiously unfair first. But consider the impact on FX on Japanese bonds. As the US$ increases in value (over 100 percent in the last few years), the value of a yen-denominated bond fall precipitously on a US$ basis. The FX part of the equation can be the biggest benefit of investing in foreign bonds. I also do not like to pay income tax on interest if I can avoid it. Foreign sovereign bonds issued by creditworthy nations can be a boon to your portfolio for a couple of reasons. First, you may be able to earn a higher interest rate on the bonds as many countries generally hold interest rates higher than the U.S. That is because of the implied safety of the U.S. sovereign bonds relative to most other sovereign bonds. Another reason is that it adds more diversity to a portfolio since there is generally less correlation between US bonds and equities relative to foreign bonds. Finally, and this is my favorite part, the FX gains can be huge. Be careful, though, now is not the time to buy foreign sovereign bonds because the US$ is still gaining in strength relative to most other currencies. When the US$ hits a high and begins to fall again relative to other currencies, it behooves us to seek out the countries with both higher yields and faster growing economies (without high debt burdens) for potentially outsized future gains. If interest rates are high and beginning to fall in that country, then can earn three ways: gains from principal value of bonds rising as interest rates fall, locked in high interest rates and gains from changes in relative values of currencies. Such circumstances do not come often, but when it happens, you want to be in the mix with at least a small portion of your portfolio. Finally, I only hold these securities in my tax-deferred accounts because of the volatility of the FX. These are investments that may do well for several years at a time, but there is a cyclicality to investing in this area and one must be ready to sell when the environment begins to change. Because I expect to be taking gains and not holding to maturity I like to avoid taxes, especially on the gains which can be substantial. Stocks of companies that I plan to hold forever, those quality companies that have an established record of growing revenues, earnings and dividends (especially dividends) can usually go into my tax-deferred accounts. As I pointed out in the previous section, it depends on where I have the cash available when I spot a great bargain. I prefer to keep these issues in my tax-deferred accounts for tax reasons even though the tax rate on dividends is low now; the rate tends to move over time, so I prefer to keep the income out of reach of our dear uncle Sam. Some folks like to keep royalty trusts and limited partnership units in a taxable account to avoid going over the limit on “income earned from other than normal business.” There is a limit of $1,000 that can be earned in tax-deferred account per individual in a year without becoming taxable. An investor needs to keep this in mind and look at previous K-1 schedules from a company (usually limited partnership or trust) to get a sense of how much income is likely to be distributed for each share annually that falls into this category. It does not take long to make that investigation and do the math. The information can usually be found under the “investors” tab on the company website as “tax treatment of distributions.” I do not own any such shares/units presently but have in the past. I did very well owning Canadian royalty trusts before the government north of the border decided to change how distributions were taxed. I sold as soon as I read what was being proposed and did not wait for the law to be voted on. It hurt because my monthly distributions from those units were about $1,900. The nice part was that a portion of each distribution was considered return of capital and free from taxes. The distributions were also considered qualified dividends then, too. I held those units in my taxable account because the effective rate on the distributions was only about ten percent. But then, I do my own taxes, so I do not have to pay an accountant to file each K-1 for me. That can cost a pretty penny (or about $80 per K-1). So, if you only want to own a hundred units and you have your taxes prepared professionally, you may save money by either holding the units in a tax-deferred account or just telling the preparer to declare the full amount as taxable income instead of filing the K-1. Here is a link to an example of how the math can work depending on your incremental tax rate. The example is about half way down the page. If annual distributions from a single K-1 total less than $1,000, it might be cheaper to pay tax on the whole amount instead of paying your preparer. The blog I linked is not the definitive answer to the question of where should I hold this type of security. The answer lies in the answers to these questions: How much of the asset do you want to own? What is your tax rate? Do you pay a preparer to file your taxes? Then do the math. It seems complicated but it really is not. And the yields can be very good. The point is that an investor could conceivably own these types of securities in either taxable or tax-deferred accounts. It depends of the answers and the math as to which is better. How I deal with foreign stock dividend withholding In a nutshell: it depends upon the bilateral tax treaty between the U.S. and the nation in which the foreign company resides. Here is a link to the IRS page with links to all the current tax treaties with foreign governments. I apologize that the treaty language is in legal jargon and may be difficult to understand. When you click on a country it brings up the original treaty document. Scroll down to the articles list and find articles that cover dividends (usually article ten) or royalties (usually article 12) if you are considering a royalty trust). First, look for the rate at which the countries have agreed to tax dividends, often 15 percent, but may be higher. Then look within the section titled “relief from double taxation” for information about refunds and/or tax credits. Some developed countries have a form to apply for a refund of withheld taxes. Often, the best you can hope for is to report the withheld tax on your filed return and then receive a tax credit equal to the difference between what you paid and what you would have paid if the dividend had been paid and taxed in the U.S. When the tax withheld is below what our tax rate is, you may find you owe additional taxes to the U.S if held in a taxable account. What you want to be certain of is that you will be able to avoid being taxed at more than the prevailing U.S. rate. In the end, by holding such securities in a taxable account, you are able to keep the tax rate down to the dividend tax rate in the U.S. One thing to remember is that if the tax rate is lower than the U.S. tax rate, you can actually keep more of your dividend by owning it in a tax-deferred account. Do your homework and save some money from the tax man every year you hold the stock. If you are a long-term investor and buy a high quality dividend paying foreign stock the savings could add up over the decades to a very nice sum. Summary This article is intended as an explanation of what I have learned from my own experience and how I plan to avoid taxes. In some cases, I find that there is no clear-cut definition of what is best without doing a little homework. I am not a tax expert nor is any of the information included in this article meant to be advice other than to provide some perspective for other investors. If any readers have better source of information links, especially for the foreign tax treaty information (in plain English), please leave a comment with those links. Any reader that has a different perspective on how to avoid or defer taxes on investments and is willing to share that information is welcome and encouraged to do so. We can all learn from each other here on SA. For convenience to readers new to this series, I have created an instablog, ” How I Created My Own Portfolio Over A Lifetime ,” with links to all the articles of this series. I will usually add a link to the blog for each new article within a day of it being published. As always I welcome comments and questions and will do my best to provide details and answers. This is one of the best aspects of the SA community. We can learn from each other and share our perspectives so that other readers can benefit from the comprehensive knowledge and experience represented here.