Ignorance is Bliss … for Your Sales Guy


Before my children understood what a lollipop was, it was very easy to swap it out with an apple slice. I was looking after their best interests, after all. But what if I wasn’t a concerned mother? What if I were a manipulative saleswoman needing to hit a certain commission level on apples that month to stay employed; or worse, to win a crystal paperweight and bragging rights among my very competitive colleagues?

My example may seem strange, but if we apply this to personal finance, and not apples, the sad truth is this is how the brokerage world operates; and it may as well be rotten apples they are selling.

Perpetuating confusion is easy when you have created your own terminology. Most adults feel very childlike in the presence of polished and seasoned salespersons who throw around terms that are never explained. It is not uncommon for investors to sign on the dotted line, heads bobbing while thinking, “How embarrassing! I feel so stupid.  How do I not understand this?”

The answer: You’re not supposed to.

Early in my career, I managed to get a full-time gig writing at an investment firm when I understood very little about that world. The one thing I did know is I didn’t speak the language. And, language is everything, if you expect to understand the world you’re in.

It wasn’t until I felt confident in the land of “financial speak” that I asked the head of Marketing why we couldn’t just write these brochures using plain English. His reply explained exactly why the terminology was intentionally so foreign: There is money in confusion.

“I don’t know anything about cars,” he said. “And, when I see an ad talking about torque and turbo charge, I know I need to speak with a professional who can explain this to me. We want the investor to realize he can’t do this on his own so that he goes to his broker.” Good for the company. Good for the broker. But, good for the investor? Not so much.

Let’s see. If you didn’t know that a Class A share mutual fund carries a sales charge that can reduce your initial investment by as much as 8.5% before it even buys one share, you have a problem.

If you didn’t realize that a Class B share will deduct a sales charge if you sell shares before a set period of time, you have a problem.

If you didn’t realize that Class C and Class D shares will carry high annual fees (because they are not charging an up-front sales charge, like the Class A share; or a back-end/deferred sales charge, like the Class B share), you have a problem.

And, if you didn’t realize that all funds can carry a myriad of fees (sales loads, redemption fees, exchange fees, account fees, purchase fees, management fees, distribution/service (12b-1) fees, “other expenses” – and that there are options with no sales charges and low management fees – you are easy to fleece.

A great source of information on fees is the U.S. Securities and Exchange Commission website.

According to the S.E.C., “Fees and expenses are an important consideration in selecting a mutual fund because these charges lower your returns. Many investors find it helpful to compare the fees and expenses of different mutual funds before they invest.”

FINRA, the Financial Industry Regulatory Authority finds this topic important enough that they have a Fund Analyzer on its site so that investors can compare the costs of funds, which is very helpful.

Clearly, these agencies are aware that investors are typically ignorant and are not fluent in the language of sales charges and fees.  I knew this already from the many investors my husband and I meet with at our fee-only fiduciary Registered Investment Advisory Firm, ATI Investment Consulting, Inc.

“Nothing. I don’t think I pay anything.” We are often told this before we review the prospective investors’ existing portfolios. Clearly, if they really believed that everything was copacetic; they wouldn’t be looking to change advisors, would they?

Without too much effort, we can scan a statement and give a pretty good idea just how much they are paying; I can assure you, it isn’t “nothing”. In fact, it’s usually egregious – like 3% a year, not counting the sales charges.

Ironically, the do-it yourself investors who realize that their portfolios are in need of more professional management have come to us having inflicted little damage to themselves. In being suspicious of the brokerage industry, they did themselves a favor and opted to invest directly in no-load, low-cost mutual funds, and didn’t blow themselves up. Of course, these fund families tend to adopt a user-friendly, “plain English” philosophy because they do not have sales people to convince an investor to buy shares. These investors may not have sophisticated portfolios that balance the risks they are taking with their time frame, goals and returns; but the most important base is covered. They are not being bamboozled.

Not speaking the language is as good as wearing a “Kick Me” sign. Make sure that you work with someone who wants to explain everything to you before you invest and avoids confusing you or distracting you with jargon. Then you will know that you have chosen the apple slice because it was good for you, not because someone was paid to trick you.

Seize Control


Years ago, when I commuted by train to New York City, I remember feeling powerless and frustrated by delays.  I would feel my blood boil if there was the threat that I would be late.  Once I accepted the fact that I was not in control of whether the train would arrive on time, and took responsibility for what I could change — my commute became downright productive.  I left myself more time to get to the station; I took an earlier train so that even if it ran late, I would still be on time; and finally, I always kept work or reading material at the ready to utilize the time spent commuting in a productive way.  Investing is a lot like the train ride.  It may be unpredictable and you may get anxious, so what can you do to make the most of this experience, instead of allowing yourself to be swept up in frustration? Plenty; but to be effective you can’t get emotional and you can’t panic.  Take this time to assess what you have been doing, and whether or not your strategy needs adjusting.  Here’s a step-by-step plan to empower you in these unsettling times:

1.  What do you own?  It is surprising how many people have tens or hundreds of thousand dollars invested, and yet they are not sure what they own, or what their portfolio is designed to do.  Looking at your asset allocation (how your investments are spread out in the investment arena) is quite important.  In fact, Ibbotson Associates, a leading authority on asset allocation, found that 92% of investment returns are determined by the types of assets owned.  Market timing (buying high and selling low) accounted for just 6% of returns, and individual security selection accounted for a mere 2% of returns.  Meet with your financial professional and discuss how your portfolio is invested not just between the broad categories, like stocks, bonds, and cash, but more specifically in what types of securities.  For example, stocks (ownership in a company) can be grouped by capitalization (size), as in large, medium, and small.  Stocks can also be classified by style:  growth stocks are those that are expected to grow quickly; value stocks are thought to sell for less than they are worth (a “marked down” item, so to speak).  Stocks can also be domestic (US), foreign, global, or from emerging parts of the world economy.  Bonds (a loan) also fall into many categories, and can be issued by the US Government (or other governments), corporations or state and local municipalities.  Alternative type investments, such as real estate, oil, or gold also can play a limited role in a portfolio and act as a hedge.  Make sure the mutual funds owned in all portfolios contain different types of securities, or you run the risk of weighting your portfolio too heavily in one area; a market correction in that area would affect your investment results twice as hard.  If you are not working with a professional, now may be a good time to consider working with a fee-only advisor,  because this analysis takes time and needs to be done thoroughly to consider and minimize investment risks.  Also, your situation may have changed since you constructed your portfolio.  Make sure your asset allocation strategy considers:

  • Your time frame/goals;
  • All investments in all accounts;
  • Investment overlap in individual stocks owned and in mutual funds;
  • Different asset classes (stocks, bonds, etc.), different market capitalizations (large, mid and small companies), different investment styles (growth, value) and different markets (US, foreign, emerging);
  • Where the investments are owned (in a taxable brokerage account, or in a tax-deferred retirement account) because investing without being aware of potential taxes can result in “giving back” your returns in the way of taxes; and
  • If the risks assumed are worth the potential reward.

2.  What is it costing you?  Having investments and not paying attention to the costs is a sure-fire way to handicap your potential returns.  If two portfolios own the same investments (such as the S&P 500 Index), but one’s fees cost 0.20% and you own the other, which costs 2.35%, immediately you have reduced your returns substantially.  In a volatile or down market, paying higher fees can make generating a reasonable return quite unlikely.  Most important, though, is what you forfeit over the long-term when you pay high fees.  As investments compound over time, the cost of high fees becomes more damaging.  Let’s assume these two investments each returned 10%.  After the deduction of fees, the returns are dramatically different: the high-cost investment returned 7.65% versus 9.80% for the low-cost fund.  After many years, these fees would really impact your bottom line.  If you invested $10,000 in each of these investments, after 30 years, the high-cost investment would be worth $91,289; and the low-cost mutual fund would be worth $165,222 – nearly $74,000 more than the high-cost investment.  Of course, this example is hypothetical and does not reflect past or future results for any investment. Click here to read more a more in-depth discussion about fees. 

3.  What is your plan?  Again, the power lies with you.  Maybe you have left your investments unattended and the stock portion of your portfolio is larger than it should be.  Maybe you have not left enough of a cash reserve to cushion the blows from difficult markets.  Perhaps you would benefit from a gradual reallocation of your assets towards a more palatable allocation that won’t keep you up at night.  Maybe you have kept too much in cash and are not earning anything and could benefit from buying low as opportunities arise in this volatile market.  Again, sit with your professional and really go over your objectives, time frame and tolerance for risk (keeping in mind, of course, that an all cash portfolio guarantees you a negative return in this low interest-rate environment).  It has been our finding in working with clients, that accepting 60% of the market’s gains is well worth the protection of declining 60% less than the market in times of trouble. We lean toward a more balanced portfolio allocation for our clients for this reason. 

Remember, until you sell something, you haven’t lost anything.  But looking for ways to buy low and adjusting your portfolio to assume less risk and to pay less in fees will certainly benefit your long-term results in a meaningful way.  The control is yours to seize.  You can choose whether to allow yourself to feel stranded, waiting for the train to pull in, or you can use this time to make sure you are ready to climb aboard when the opportunity presents itself.

 We’re here to help should you need guidance: contact ATI Investment Consulting, Inc. at 631.675.1420.


3 new realities of retirement


3 new realities of retirement

Think about your parents’ retirement for a minute. Their lives most likely look a whole lot different than their parents’. Your grandfather probably stopped working the very day he turned 65. He and your grandmother might have hit the links or the beach while they collected pension checks that they supplemented with high-yielding investments.

But, today’s retirees are living longer, working longer, reinventing themselves and staying active — all while trying to figure out how to pay for this great new chapter in their lives. They usually can’t rely on pensions, high interest on savings or health care benefits from former employers.

Call it revolving retirement. The term, coined by Strategic Business Insights’ Consumer Financial Decisions group, describes retirees who re-enter the workforce in one way or another either to fulfill an emotional need or make ends meet. They may find they’re bored with retirement or want to start a new career. With all this change comes confusion and sometimes some misguided assumptions.

“Frankly, a lot of myths about retirement are floating around out there,” says Thomas Rowley, director of retirement business strategy at Invesco Consulting. To help set things straight, we asked top demographic and financial experts to help bust some of those myths and offer advice on how best to prepare for a fast-changing future.


That’s how much a 65-year-old male will need to cover health care costs for the rest of his life.

Source: Employee Benefits Research Institute, 2012.

MYTH: Luckily, I won’t need to worry about health insurance. Medicare will kick in when I’m 65.

REALITY: Most experts agree Medicare will be around in its present form for some time to come. But, people often misunderstand the limitations of Medicare. It doesn’t cover everything, especially long-term care. Consider the fact that a 65-year-old male will need more than $300,000 to cover health care costs for the rest of his life, according to 2012 research from the Employee Benefit Research Institute.

You need a solid health care costs strategy in place to deal with several factors. For instance, have you purchased long-term care insurance, or do you think you have saved enough for those potential expenses? If your company offers a health savings account, is this a viable option for you that you could roll over into retirement? (Earnings on savings for eligible health care expenses grow tax-free.) Do you intend to retire before you will be eligible for Medicare (at age 65)? If so, how do you plan to pay for health insurance coverage? Ask your advisor about strategies that can help cover health care costs in retirement.

MYTH: My taxes will be lower in retirement.

REALITY: Conventional wisdom has long held that your tax bracket, along with your income, will decline in retirement. But, that may no longer be the case. Taxes may continue to rise as the government struggles with the ongoing debt crisis over the next 10 to 15 years, says Russell Price, Ameriprise Financial senior economist. How you withdraw your retirement savings and how much you plan to spend each year will also affect your taxes. You want to make sure you have a good mix of taxable, tax-deferred and tax-free investments.

MYTH: My traditional asset allocation will definitely give me enough income.

REALITY: With persistent low interest rates over the past several years, some retirees are finding their savings aren’t generating the income they had hoped for. Proper diversification among a wide range of asset classes is key. With the right mix, you may be in a better position to handle market volatility, generate more yield to boost income and protect your portfolio from downturns in any one specific asset class. Your advisor can help you choose the asset allocation and diversification strategy that’s right for you. (Please see the following piece on alternative investments.)

Talk to your advisor about the best strategies to help you save for a long and fulfilling retirement.

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*Ameriprise helped pioneer the financial planning process more than 30 years ago. We have more financial planning clients and more CERTIFIED FINANCIAL PLANNER™ professionals than any other company in the U.S. based on data filed at and documented by the Certified Financial Planner Board of Standards, Inc. as of Dec. 31, 2012.

Thomas Rowley, Invesco Consulting and Strategic Business Insights are not affiliated with Ameriprise Financial.

Asset allocation and diversification do not assure a profit or protect against loss in declining markets.

Alternative investments involve substantial risks and are more volatile than traditional investments, making them more suitable for investors with an above average tolerance for risk.

Investment products, including shares of mutual funds, are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.

Ameriprise Financial and its representatives do not provide tax advice. Consult with your attorney or tax advisor regarding specific tax issues.

Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services, Inc. Member FINRA and SIPC.

© 2013 Ameriprise Financial, Inc. All rights reserved. P1 – 8/13


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You have dreams for retirement. But you need to understand six common risks most retirees face and take steps to protect your retirement dreams from these risks:

1. Health care expenses. Medical costs have risen at more than twice the rate of overall inflation in recent
decades.1 That trend is especially problematic for retirees, who on average spend a greater percentage of their income on health care costs. The Employee Benefit Research Institute estimates that the average husband and wife who turned 65 in 2010 will need roughly $250,000 in savings to pay for health care expenses not covered by Medicare during their retirement.2 Imagine how high these costs could be when you retire.

2. Unexpected events. Unplanned developments in your life can have a major impact on your finances. Some may be personal: a lawsuit, a family member in need. Others may be external, such as changes to tax laws, Social Security or a pension. All of these events could force you to withdraw money from savings and perhaps even jeopardize your retirement accounts.

3. Market volatility. The growing interconnectedness of world economies and the ever-increasing speed of global capital flows have made the markets more volatile than ever. If you don’t have a sound investment plan coupled with an emergency cash strategy, a large drop in financial markets at home or abroad could reduce the value of your retirement accounts. Volatility can be particularly damaging to a portfolio during retirement when you’re withdrawing assets; selling long-term assets at depressed levels can reduce the value of your portfolio, forcing you to lower your income in retirement.

4. Longevity. The risk of outliving one’s assets is of great concern in a time of rising life expectancies and earlier retirements. The average 65-year-old man can expect to live more than 20 years, while the average 65-year-old woman is likely to live at least 23 years. And if you’re married, you have an excellent chance of living longer: A 65-year-old couple faces a 50% chance that one spouse will live past 92, and a 25% chance that one spouse will live to 97.3

5. Inflation. Some economists believe inflation is likely to climb in the years ahead. But even at low rates Inflation can deteriorate the buying power of your savings. In fact, 24 years from now, inflation will nearly double the cost of living for the typical consumer, based on the historical annual average of 3%.

6. Withdrawal rate. Pulling too much from savings early in retirement increases the risk that you could outlive your money. That’s because early withdrawals can leave you with a smaller asset base, which means less opportunity for growth over time. 

Each of these risks can build on the other, making it crucial to manage them all properly. For example, a
market downturn could reduce the value of your retirement accounts, increasing the risk that excessive withdrawals could exhaust your savings early.

By taking action today, you have the potential to make your retirement everything you’ve always dreamed of.
An Ameriprise financial advisor can help you construct a complete plan that includes solutions to address these risks while also helping you meet your financial objectives — all within the context of your individual situation and goals — so you can feel more confident about retirement.


1Bureau of Labor Statistics, February 2011. Refers to period 1965–2010.
2 “Savings Needed for Health Expenses in Retirement: An Examination of Persons Ages 55 and 65 in 2009”, Employee Benefit Research Institute, June 2009.
3Annuity 2000 Mortality Table.

Tax-Exempt Bond Fund (Municipal Bonds)


What is a tax-exempt bond fund?

A tax-exempt bond fund (sometimes known as a municipal bond fund or muni bond fund) invests in tax-exempt municipal debt instruments issued by state governments or agencies, counties, cities, towns, or other political districts. From the shareholder’s point of view, the key feature associated with these funds is the advantageous income tax treatment they receive. This income tax treatment is generally the same as that enjoyed by holders of individual municipal bonds. Just as interest paid by municipal bonds is generally tax exempt at the federal level, so the income generated by municipal bond funds will also be free from federal income taxation.

Further, as with income produced by municipal bonds, the dividends paid by these funds may be exempt from state and local taxes as well. The dividends you received from a tax-exempt bond fund would likely avoid state income tax only in proportion to the percentage of total fund income attributable to securities issued in your home state. Any portion of income earned by securities issued outside your home state might be subject to state taxation.

The tax advantage means that, depending on your tax bracket, the after-tax return from a tax-exempt bond fund could actually be higher than that of a taxable bond fund.

Caution:  Keep in mind that while dividends derived from income may be tax exempt, dividends derived from capital gains are not.

Caution:  If you are subject to the alternative minimum tax (AMT), you must include interest income from certain municipal securities in calculating the tax unless the securities are specifically exempted from the AMT. For example, the American Recovery and Reinvestment Act of 2009 specifically exempts interest on private activity bonds issued in 2009 and 2010 from being included in AMT calculations.

What is a state tax-exempt bond fund?

As noted above, any state income tax advantage applies only to income from bonds issued in the taxpayer’s home state or local municipality. However, some tax-exempt bond funds, known as state tax-exempt bond funds or single-state muni bond funds, invest exclusively in debt instruments issued by a particular state. A California tax-exempt bond fund, for instance, holds only bonds issued by or within the state of California. For residents of the state that issues the bonds–in this case, California–income from the fund is free from both federal and state income tax; residents of other states receive the federal but not the state tax benefit.

If you live in a local municipality (for example, a city or town) that levies its own taxes, a portion of your fund income may avoid those taxes as well if some of the bonds held by the fund were issued directly by your municipality.

Tip:  There are state tax-exempt bond funds for almost every state in the United States.

When can it be used?

Tax-exempt bond funds may be suitable for somewhat conservative investors who want to invest in mutual funds without the volatility that may accompany stock funds and certain corporate bond funds. They are appropriate for investors seeking current income and for individuals in high tax brackets who want to minimize their income tax liability. Investors with more modest levels of income may not benefit as much from the tax treatment, however. The income they provide also can be used to help moderate volatility from other investments in a portfolio.

Income tax benefits

The tax advantages are the greatest strength of tax-exempt municipal bond funds. Not only is the income generated by these funds free from federal taxation, but it may avoid state and local taxation in some cases as well. Investors may even enjoy triple tax-exempt treatment. This might occur, for instance, in the case of a New York City resident who would avoid federal, state, and city taxes on the portion of fund dividends representing income earned by New York City bonds. If you pick the right fund, these tax savings can significantly reduce your total tax bill. In general, the higher your tax bracket, the more attractive the tax benefits become.

Provides current income

Most bond funds seek to provide current income. However, these funds may provide a more reliable source of current income than most other bond funds. Even if you don’t need the extra income, you can still reinvest your dividends, or simply allow the income to help moderate the volatility of your portfolio

May carry lower risk than some other bond funds

Though it’s not impossible for state and local governments to default on bonds, the default rate on munis historically has been lower than that for corporate bonds (though past performance is no guarantee of what might happen in the future, of course). Because governments are generally able to raise taxes if necessary to pay their debts, muni bonds as a whole are considered a relatively conservative bond choice. And by investing in debt from a variety of issuers, a bond fund reduces the impact of possible default by a single governmental body.

Generally modest returns

The return on a given tax-exempt bond fund depends on several variables that affect municipal bond yields, including local economic factors and quality ratings assigned to specific securities. Because of their tax advantage, returns are generally expected to be lower than with other investments (though as noted above, the tax advantage also means that depending on an investor’s tax bracket, the net return could actually be higher than that of a taxable bond fund).

Susceptible to interest rate risk and inflation risk

When interest rates rise, bond prices fall. When interest rates go down, bond prices rise. Shares in a bond fund that you may have bought when interest rates were low can lose value as interest rates increase because the existing bonds in the portfolio aren’t as valuable as newer bonds that pay higher interest rates. (However, one advantage of having a bond fund is that the fund’s manager also can adjust the portfolio over time to take advantage of those higher-paying bonds.)

Inflation risk refers to the possibility that the return on your investments won’t keep pace with increasing price levels. As prices rise, the value of a dollar falls, resulting in a decreased ability to purchase goods and services. Bonds that offer a fixed interest rate assume this kind of risk. If the overall interest paid by the bonds in your fund is lower than the inflation rate, your investment dollars may not grow enough over the years to allow you to reach your financial goals. And if you rely on the fund for current income, those payments may lose purchasing power to inflation over time.

As with all bond funds, both tax-exempt and state tax-exempt bond funds never mature as an individual bond does. Therefore, they don’t offer the same assurance that your principal will be returned to you at some fixed future date. Before investing, carefully consider a fund’s investment objectives, risks, fees, and expenses, which can be found in the prospectus available from the fund. Read it carefully before investing, as you would with any mutual fund.

State tax-exempt funds offer less diversification

The trade-off for receiving a greater tax advantage from a single-state muni fund focused on your state is the greater risk involved in a more narrowly focused fund. Because the fund’s holdings are limited to the bonds of one state, it has less protection from the impact of local economic problems. For example, if a state is heavily dependent on an industry that experiences an economic downturn, its finances (and those of the cities and towns in it) could be at greater risk of struggling to meet debt payments. If your job might also be affected by the same circumstances, that would put you doubly at risk.

Also, some states may have legal requirements that make it more difficult for a governmental body to raise taxes, even to pay its debts. Though diversification alone can’t guarantee a profit or ensure against a loss, municipal funds that invest in bonds issued by multiple states may offer greater diversification and more diluted risk.

Investment Tax Planning



Investment planning can be important for several reasons. However, any discussion of investment planning is incomplete without a thorough understanding of the applicable income tax ramifications. Tax planning can help you reduce the tax cost of your investments. Once you’ve created an investment plan to work toward your various financial goals, you should take advantage of the tax rules to ensure that you maximize the after-tax return on your investments. In other words, your goal is to select tax-favorable investments that are consistent with your overall investment plan.

In order to engage in investment tax planning, you need to understand how investments are taxed (including the concepts of capital gain income and ordinary income) and how to compare different investment vehicles. You also need to know how your own tax situation (i.e., your tax bracket, holding period, and tax basis) affects the taxation of your capital assets.

Caution: Investment choices should not be based on tax considerations alone, but should be based on several factors including your time horizons and risk tolerance.

Caution: Starting in 2013, a new 3.8 percent unearned income Medicare contribution tax will be imposed on the investment income of high-income individuals (generally, married individuals filing jointly with modified adjusted gross income (MAGI) exceeding $250,000, married individuals filing separately with MAGI exceeding $125,000, and single individuals with MAGI exceeding $200,000).

How does investment tax planning work?

Similar investments may carry substantially different tax costs. It is important to identify the differences and evaluate the costs. Consider the following points:

Investment earnings are taxed in different ways

A myriad of investment vehicles are available to you. For instance, you can invest in stocks, bonds, mutual funds, money market funds, real estate, commodities, or your own business. Investment earnings are taxed in many different ways. Consequently, some investments earn less after tax than others. By taking advantage of these differences, you may save money. In addition, your tax savings can preserve your investments and, as a result, enhance future investment growth.

Investment tax planning can maximize your wealth

Tax investment planning involves maximizing the after-tax return on your investments. This is beneficial because the wealth that remains after you pay your taxes is ultimately more important to you than the value of your investments. It’s the after-tax payout that enables you to finance a home, a child’s education, a vacation, or your retirement. Thus, one goal of investment tax planning is to maximize future wealth. To do so, you need to know a little bit about taxes. In particular, you need to know the following:

  • How your investments are taxed
  • The before- and after-tax rates of return on your investments
  • How to compare investments in light of after-tax return
  • How are your investments taxed?
  • In order to understand how investments are taxed, you first need to become familiar with the following basic concepts:
  • Capital gains and losses
  • Qualified dividends
  • Ordinary (investment) income
  • Investment expenses
  • Tax-exempt income
  • Tax-deferred income
  • Capital gains and losses

While you hold a capital asset (e.g., your home, stocks, bonds, mutual funds, real estate, collectibles), you will not pay taxes on any increase in value. However, when you sell or exchange the asset, you will realize a capital gain (if you sell it for a profit) or loss (if you sell for less than the asset’s cost). If you sell an asset after only a year or less, you will have a short-term capital gain. Short-term capital gains are taxed at ordinary income tax rates (i.e., your marginal income tax rate). If you own an asset for more than a year before you sell it, you will have a long-term capital gain.

Long-term capital gains tax rates are generally more favorable than ordinary income tax rates. Currently, the highest ordinary income tax rate is 35 percent whereas the highest long-term capital gains tax rate (for most assets) is 15 percent (for sales and exchanges on or after may 6, 2003). That’s a difference of 20 percent. Thus, holding an asset for long-term growth is a tax-saving strategy.

Caution: The Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act), the Tax Increase Prevention and Reconciliation Act of 2005 (2005 Tax Act), and the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Act) reduced long-term capital gains tax rates for sales and exchanges made on or after May 6, 2003 and before January 1, 2013. These rates are 15 percent for taxpayers in marginal tax brackets higher than 15 percent, and 5 percent (zero percent in 2008-2012) for taxpayers in the 15 percent and 10 percent marginal tax brackets. In 2013, the rates revert to pre-2003 Tax Act levels–20 percent and 10 percent, respectively. Thus, investors may want to time the sale of highly appreciated assets to take advantage of the lower rates.

You may offset capital gains with capital losses (short-term losses against short-term gains and long-term losses against long-term gains). If you have more losses than gains in a given year, you may offset up to $3,000 of ordinary income ($1,500 if married filing separately). Any remaining losses can be carried forward into future tax years. Thus, timing losses to offset gains is a tax-saving investment strategy.

Tip: You may also elect to include net capital gains from property held for investment as ordinary (investment) income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you don’t have capital losses, but do have investment interest expenses. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made–if you do not make the election, the IRS will classify the income as capital gain income.

Capital gain is computed by subtracting the sale price from the asset’s basis. Basis is your cost and includes the price you paid for the assets plus the cost of capital improvements. The higher your basis, the smaller your capital gain and the smaller your tax liability. Thus, you should keep careful records of the basis of an asset. This is especially important if you buy shares of stock in the same company at different times and different prices. This will allow you to control the tax consequences by picking particular shares to sell or hold.

Tip: If you want to sell an asset now but defer the recognition of the gain until later tax years, you may be able to arrange an installment sale with the buyer (but not for stocks or bonds). That way, you report and pay tax on the income as you receive it.

Qualified dividends

Qualified dividends are dividends received during the tax year by an individual shareholder from a domestic corporation or a qualified foreign corporation. Under the 2003, 2005, and 2010 Tax Acts, effective for tax years 2003 through 2012, such dividends are taxable at the same rates that apply to long-term capital gains. This tax treatment applies to both regular tax and the alternative minimum tax. Absent further legislative action, dividend tax rates revert to pre-2003 Tax Act levels (i.e., they will be taxed at ordinary income tax rates) beginning in 2013.

Eligible dividends include dividends received directly from a domestic corporation or a qualified foreign corporation as well as qualified dividends passed through to investors by stock mutual funds, other regulated investment companies, partnerships, or real estate investment trusts (REITs). Thus, it may be advantageous to invest in vehicles that pay qualified dividends, especially if you need current income.

Distributions from tax-deferred vehicles, such as IRAs, retirement plans, annuities, and Coverdell education savings plans, do not qualify even if the funds represent dividends from stock. Thus, holding investments that pay qualified dividends within a tax-deferred plan may no longer be desirable.

Tip: Though qualified dividends are taxed at long-term capital gains tax rates, they cannot be offset by capital losses. However, as with capital gains, you can elect to include these dividends in investment income. If you do so, such income will be taxed at ordinary income tax rates, not capital gains tax rates. This may be advantageous if you have investment interest expenses in excess of investment income. Investment interest expense may only be deducted to the extent of investment income (though it can also be carried forward to future years). This election must be specifically made–if you do not make the election, the IRS will classify the income as net capital gain.

Ordinary (investment) income

Ordinary investment income consists of any investment income that is not capital gain income, qualified dividends, or tax-exempt income, and is taxed at ordinary income tax rates. Investment income is generated by investment property such as bonds and bond mutual funds. Examples of ordinary investment income include interest and dividends that are actually interest (and therefore don’t qualify for taxation at long-term capital gains tax rates).

Generally, ordinary income tax treatment is not as favorable as long-term capital gains tax treatment.

Investment expenses

If you borrow money to buy investment property, you probably pay investment interest. Investment interest may be used to offset investment income only. Excess investment interest may be carried forward to future years. Other investment expenses (e.g., commissions, fees) are deductible as an itemized deduction on Schedule A and are subject to the 2 percent limit.

Passive income and losses

A passive activity is an investment in a business in which you are not an active participant. Rental real estate and limited partnerships are two common examples. Income generated by a passive activity and gain from the sale or exchange of a passive activity is included in passive income and taxed at ordinary income tax rates. Generally, losses from passive activities may offset income from passive activities only–they cannot be used to offset ordinary income or capital gain income. However, excess losses in a given year can be carried forward into future tax years.

Tax-exempt income

There are a number of tax-exempt investment vehicles. One of the more common vehicles is the municipal bond. Usually, interest paid on municipal bonds is not subject to federal or state tax (at least not in the state of issue). When deciding whether to invest in taxable bonds or tax-exempt bonds, it is important to compare the after-tax rate of return on municipals with that on taxable bonds with similar risk.

Caution: While the interest on municipal bonds is tax exempt, capital gains tax may be imposed when you sell the bonds.

Caution: The interest on U.S. Government bonds is not exempt from federal income tax. However, the interest on federal securities is tax exempt at the state level.

Tip: Roth IRAs, although technically vehicles for holding investments and not truly investments themselves, should be discussed under the heading of tax-exempt income. A Roth IRA is a vehicle in which you can invest a limited amount of money each year for retirement and certain other limited purposes (assuming that you satisfy certain criteria including adjusted gross income (AGI) limits). The income and gains on the account are not taxed at all as long as you follow all applicable rules. Be aware, though, that if all applicable rules are not followed, withdrawals will not only be subject to tax, they may also be subject to a penalty. Tax-free growth is clearly one of the most powerful investment tools available for creating wealth. However, you must use after-tax dollars to make the initial investment and subsequent contributions. No IRA deduction is allowed for contributions to Roth IRAs.

Tax-deferred income

Tax-deferred investments produce earnings that are not taxed until withdrawn. These earnings are reinvested and continue to fuel investment growth. This is one of the most powerful investment tools available. First, there is a time-value of money advantage. The longer you can keep the money in your own pocket and out of the hands of the IRS, the greater the potential benefit will be to you. Second, since our income tax rates are progressive, you may find yourself in a lower tax bracket in the year the earnings are finally taxed. If so, the actual amount of tax paid on those investment earnings will be less. On the other hand, if you find yourself in a higher tax bracket in the year the earnings are finally taxed, the amount of tax paid on the earnings will be higher (assuming all else is equal).

Caution: Many retirement vehicles are designed to provide tax-deferred growth. The downside of this benefit is that all distributions from the retirement plan are taxed at ordinary income rates rather than at capital gains rates. This can result in potentially higher taxation in light of the progressively higher ordinary income tax rates.

What are before- and after-tax rates of return?

To compare investments, you must understand before- and after-tax rates of return. Ultimately, you want to compare the after-tax rate of returns of similar investments. The rate of return is the ratio of the annual amount an investment earns compared to the cost of the investment. Thus, if an investment cost you $10 and earned $1, the rate of return is 10 percent.

Before-tax rate of return

The before-tax rate of return is the annual market-rate of return. For example, a $10 bond that pays $1 per year in interest and is sold for $10 earns a 10 percent before-tax rate of return.

After-tax rate of return

The after-tax rate of return is the ratio of the after-tax income and gain to the amount invested. With the exception of tax-free investments, this rate is always lower than the before-tax or market rate of return. What do you need to know to compute the after-tax rate of return? Generally, you need to know the following:

What is the tax treatment of your investments (ordinary income, capital gains, tax exempt, tax deferred)?

What is your tax situation (your marginal tax rate, your holding periods, whether you’ve invested in tax-deferred retirement accounts)?

How do you comparison shop for investments?

Comparison shopping for investments allows you to compare the after-tax return on two similar investments. In order to effectively make this assessment, you must consider two other issues:

Tax classification of the investment

Your tax situation

Tax treatment of the investment

You need to know whether the investment vehicle generates capital gains, ordinary income, tax-free, or tax-deferred income. There are two components to the after-tax rate of return: the portion attributable to earnings (such as interest) and the amount derived from a subsequent sale. You also need to know whether any capital gains will be treated as long-term or short-term capital gains.

Special rules can apply to certain kinds of investments such as wash sales, qualifying small business stock, short sales, installment sales, like-kind exchanges, and others. In addition, you may wish to know about market discount rules, anti-conversion rules, and tax shelters.

Your tax treatment

Your investment tax situation depends on several factors. In particular, you’ll need to know the adjusted tax basis of your capital assets, the sale price of the assets, the holding period, the amount of the capital gain or loss, the amount of your ordinary investment income or losses, and your marginal tax bracket.