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Investments Built to Defer Annual Tax Bite

Mutual funds holding municipal bonds or broad market index funds are tax-efficient

CHICAGO — If you invest in mutual funds, chances are that you’re well aware of how management fees can impact the returns on your portfolio. Knowing about them and working to keep them at a minimum are an important part of maximizing your investment returns. While these costs are an obvious element in long-term returns on your investments, they aren’t the only cost that you need to understand and control. Arguably, managing taxes are an even more important demand on your investing skills.

According to one study, taxes on the average domestic mutual fund have amounted to about 2% of the annual return over a long period of time. With the average return on stocks over that period being a little over 10%, the tax bite eats up about 20% on the overall return. That’s a very high cost, certainly even higher than management fees on mutual funds.

Taxes are inevitable, of course; there’s no way to eliminate them, but keeping them as low as the law allows can greatly increase total return on your investments.

Perhaps the most important of the investment taxes is capital gains, which consist of long-term gains and short-term gains. Long-term gains are levied on profits made from the sale of investments held for more than one year. For most investors, taxes on long-term gains are 15%.

Taxes on short-term gains (profits on investments held for one year or less) are levied at ordinary income tax rates, which can be as high as 35%. Keep in mind that most dividends are taxed at the same rate.

Deferring taxes as long as possible is an important way to minimize your tax bite. Every year that you can defer the payment of taxes means a year in which you avoid paying that annual tax bite, which keeps more of your money working for you.

There are two kinds of accounts available to most investors today: taxable accounts and tax-deferred accounts such as IRA, 401(k) and 403(b) in which taxes are deferred until later when taxable withdrawals are made. Obviously, keeping as much money as possible in tax-deferred accounts is an important way to minimize taxes on investments.

If you’re like most investors, you own both taxable and tax-deferred accounts. If so, you’ll want to make sure that you hold the right types of investments within each of these types of accounts. This approach to minimizing investment taxes is often called asset location, which differs from the term asset allocation.

Chances are that you’re familiar with asset allocation, referring to the task of proportioning investments among stocks, bonds, and cash in a way that takes into consideration such things as risk tolerance, age, and investment objectives. But you may not be familiar with asset location, which refers to the task of putting the right types of investments into the right types of accounts for the purpose of minimizing investment taxes. For example, if you have tax-free investments such as municipal bonds, you would place them in your taxable accounts since no tax would be due.

If you have taxable investments such as mutual funds holding stocks, you would put them in your tax-deferred accounts for the purpose of deferring taxes on capital gains or income distributions. However, if all or most of your investments are in one type of account, for example, a 401(k), it’s still beneficial to pay attention to your asset location. But this is especially important and offers more benefits if you own both taxable and tax-deferred accounts, especially if they are in roughly equal amounts.

Another important consideration is your time horizon. The longer you have to defer taxes, the greater the benefit; the younger you are when you start deferring taxes, the more impact it’s going to have. If you’re close to age 70½ when you will have to take required minimum distributions (RMDs)—which are taxable—from your tax-deferred accounts (except Roth IRAs), the benefit will be less because you have less time to defer taxes.

Also, it’s important to keep watch on the number of transactions in taxable accounts. The more you buy and sell in taxable accounts, especially selling profitable investments, the higher the taxes on capital gains. Even in tax-efficient mutual funds, buying and selling frequently could offset the benefit of choosing them.

In general, what makes a mutual fund tax-efficient or tax-inefficient depends on what type of investments it holds and whether it produces a high level of taxable income. Tax-efficient examples would be funds holding municipal bonds or broad market index funds, because they usually have low turnover resulting in less capital gains.

Tax-inefficient funds include those holding taxable bonds, because most of their income can be taxable. High-dividend-paying equity funds would be another example.

While monitoring investments to keep taxes to a minimum requires a bit of work, doing a good job can make a significant improvement in the overall return in your portfolio.

Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an accountant or tax adviser for advice regarding your particular situation.

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Have a question or comment? E-mail our editor Dave Davis at [email protected] .