Tuesday, April 17, 2012

Musings On Taxable Year 2011

Today was the last day for American citizens to file their federal tax returns for tax year 2011.  This calls for some reflection.  This year's tax filing deadline happily coincides with Tax Freedom Day for the first time I can recall (not that I paid attention in years past, but I'm not the one responsible for the calculation).

I learned a couple of things from reviewing my filing documents for 2011.  My realized short-term capital gains were lower in 2011 than they had been in 2010 because I didn't pursue as much event-driven investing, particularly M&A activity.  I tracked a flurry of mergers in the fall of 2011 but chose not to act on them because of the precarious nature of this bull market in equities.  I simply do not know when the bottom will fall out.  I was thus unwilling to risk going long-equity or short-put with stocks that were M&A targets because I did not want to risk holding something if a market crash forced a merger to unwind.  Stuff like that does happen.

I also learned that my tolerance for buying outstanding municipal bonds at a premium had some beneficial effects.  The premiums I paid, small though they often were, helped negate the capital gains I realized from selling equities and writing covered calls.  The net effect was to reduce the taxable amount of some of my gains while I collect the tax-free interest payments from the munis.  The only drawback was the negative effect of the accrued interest I had to pay out on bonds that were outstanding issues held by my brokerage on behalf of the underwriter.  It wasn't too much of a big deal because I always hold bonds to maturity, so the next coupon pays me back.  After that, the rest of the tax-free cash flow keeps rolling in.

I have no reason to be smug about using muni bonds this way in the near future.  I'm not buying any more fixed income instruments due to the severe threat of hyperinflation in the U.S.  My remaining California muni bonds will mature this summer and I will not replace them.  Some combination of TIPS and their ETFs, foreign currency ETFs, and hard assets (oil/gas/pipeline) MLPs and their ETFs will replace them in my asset allocation strategy.  I have convinced myself that those things will more effectively preserve my purchasing power and generate more yield than traditional fixed-income instruments in a high-inflation scenario.  The next year or two will determine whether I am making the right choice.