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Did you know that, in China, it's possible to buy insurance for some pretty crazy things? You can, for example, buy insurance that will pay out if your child displays "mischievous and destructive" habits, or your favourite team is defeated in the World Cup (both of which happened to me in the past few months; I could have been wealthy if I had been living in China).

I'd love to see a policy that pays out if the taxman decides to increase taxes on investment income. Although, given the likelihood of this happening, I suppose no insurer would touch it with a 10-foot pole. So, what's an investor to do to reduce the impact of taxes on a portfolio?

Tax-smart investing
Now, I'm not suggesting that you put taxes ahead of the merits of an investment itself, but if you can take steps to minimize the tax on your portfolio, you can add significantly to your net worth over time. A study headed up a few years ago by Professor Moshe Milevsky from the Schulich School of Business showed that returns equal to 1.35 per cent annually were lost to income taxes over the 10-year period and the 340 mutual funds he examined. If you could save that 1.35 per cent annually, you could increase the value of your portfolio by almost one third over 20 years.

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By the way, the responsibility for tax-efficiency should fall on the shoulders of two individuals: You (the investor), and your money manager (if you don't manage your money yourself). Each of you needs to consider what we're about to discuss.

At the end of the day, there are four pillars of tax-smart investing: (1) control the timing of income, (2) control the type of income, (3) control the location of income, and (4) control the offsets to income (deductions, credits and losses that may be used to reduce your taxes on investment income). Today, let's consider the first of these.

Timing of income
All other things being equal, you'll be better off paying a tax bill far in the future than paying it today. The value, of course, lies in your ability to use those dollars to generate returns between today and the time you have to pay the taxman. A $100 tax bill today that is deferred for 10 years will cost you just $61 in today's dollars, if we assume a 5 per cent return annually.

Here are some ideas to consider as you look to control the timing of your income and the resulting taxes:

Defer the liquidation of investments.
You can control the timing of any taxable capital gains by simply deferring the sale of investments that have appreciated in value. Again, don't ignore the merits of the investment here; if it's no longer a good investment, deferring the sale may not make sense.

Keep portfolio turnover low.
Turnover is the number of times in a single year that the investments in your portfolio are sold and the proceeds reinvested. You'd be surprised at how high turnover can be in some mutual funds (well over 100 per cent). The lower the turnover, the lower the taxes annually, assuming a growing portfolio.

Watch the style of money management.
Understand the approach of your money manager. A value-oriented approach will generally result in lower taxes annually than a growth or momentum style approach. A passive approach is generally more tax-efficient than an active approach. You might still prefer a less tax-efficient approach if you believe the returns will justify it, but look for returns that are 1 to 2 per cent higher than with a more tax-efficient approach, to justify the investment.

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Evaluate the timing of distributions.
If you're invested in funds, a sale of securities inside the fund can create a distribution of taxable capital gains without providing an increase in the value of your investment. If you buy into an established fund that has a large accrued gain, beware that you may be buying into a near-term large taxable distribution.

Remember the hurdle rate.
If you choose to sell an investment, and pay some tax as a result, you'll need to earn even more on the next investment to make up for the capital lost to income taxes. Call this the "hurdle rate." As a guideline, look for 2 to 3 per cent higher returns on the next investment than what you could have achieved with the current investment, to compensate for the taxes lost on the sale.

Next time, I'll continue this discussion with a focus on more pillars of tax-smart investing.

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.

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