Christine Benz: Morningstar.com has lots of great features and tools to help improve your portfolio's after-tax return.
One way to save on taxes is to set up and contribute to an IRA. If you contribute to a Roth IRA, your earnings will grow on a tax-deferred basis, and you won't owe any taxes at all when you begin withdrawing your assets in retirement.
If you contribute to a traditional IRA, your earnings will also grow on a tax-deferred basis, and although you will owe taxes when you begin withdrawing your assets, you may be able to deduct your contribution on your tax return.
So, how do you decide which IRA type makes sense for you? That's where Morningstar's IRA calculator comes in. It can help you decide whether the Roth or the traditional IRA is the better bet. It can also help you decide whether it makes sense to convert your traditional IRA to a Roth IRA.
To get to the calculator, click on the tools tab at the top of the Morningstar.com page. The IRA calculator is toward the bottom of the page on the right-hand side.
Let's start by clicking on the eligibility button to see what type of IRA you can contribute to. You'll have to supply a little bit of information such as your income, whether you participate in a retirement plan at work, and your tax filing status; for example, if you're a single filer or part of a married couple filing jointly.
Once you've entered your information, click submit to see if you can contribute to a Roth IRA, a traditional deductible IRA, or a traditional non-deductible IRA.
Roths have become very popular because you'll be able to withdraw your earnings on a tax-free basis when you retire. But, if you earn too much, you may not be able to make a contribution to a Roth.
If the calculator tells you that you can contribute to more than one IRA type, you can click on the comparison tab. That will help you determine which one will yield the best return. You can also click on the conversion tab to gauge whether conversion makes sense for you.
So, what if you're already contributing the max to your tax-sheltered accounts like an IRA, but would still like to minimize your tax-related investment costs?
One idea is to look at individual stocks, index funds, or exchange-traded funds, all of which tend to incur fewer tax-related costs than conventional mutual funds.
To the extent that you hold conventional mutual funds, it pays to check up on just how tax efficient those funds really are. To check up on your holding's tax efficiency, simply type the fund's ticker in the quotes box at the top of the Morningstar.com page.
Once you're on the main page for that fund, click on "Tax Analysis" in the left-hand navigation bar. You'll see an array of tax-related data for that fund.
One statistic to focus on is the tax cost ratio, which is a Morningstar.com exclusive. Think of the tax cost ratio much as you would an expense ratio. It's the percentage of a fund's return that an investor in the highest tax bracket would have surrendered to taxes.
In the case of a fund like this one, you'll see that the tax cost ratio is pretty high, even higher than the fund's expense ratio. Over the past three years, the tax cost ratio is more than two percent.
The fund has still been able to deliver strong returns on an after-tax basis, but you would have been able to pocket a greater share of those gains if you had held the fund in a tax-sheltered account like an IRA.
Shareholders in this fund, by contrast, haven't given up much of their gains to taxes. Over the past five years, its tax cost ratio is zero, meaning that investors in taxable accounts haven't had to pay any taxes if they've bought and held the fund.
This fund is specifically managed to limit the tax collector's cut and is a good example of what you want to look for when buying funds for your taxable accounts.
One other way to save on taxes is to hold tax-exempt investments. An old-fashioned but effective strategy is to hold municipal bonds and bond funds in place of taxable bonds and bond funds.
As you can see by looking at the tax analysis section for this fund, taxable bond funds often have very high tax cost ratios. That's because income from most bonds and bond funds is taxed at your ordinary income tax rate, which can run as high as 35 percent.
Most income from municipal bond funds, by contrast, isn't subject to federal income tax. The trade off for municipal bonds and bond funds is that because they offer tax savings, they don't typically yield as much as taxable funds on a pre-tax basis.
But, depending on your tax situation, you may still come out ahead with munis. To determine whether a municipal or taxable bond fund is the better bet for you, find the yield for the taxable fund and the yield for the muni fund you're considering.
You can find a mutual fund's yield on the main page for that fund. Write these numbers down. Then, go to Morningstar's bond calculator, which is located on the tools tab of Morningstar.com.
In the description underneath the words "Bond Calculator," click on the words "Tax-Equivalent Yield." Enter the yield for each fund.
If you're considering a municipal bond fund that invests only in bonds issued by municipalities in your state, its income would typically be exempt from state income tax.
On the other hand, if the muni fund lands in one of our municipal national categories, its income would not be exempt from state tax.
After that, fill in your federal and state tax rates, then click "Calculate." You'll see the taxable fund's yield, and you'll also see the muni fund's yield once the tax savings are factored in.
In this case, we see that someone in the 28 percent tax bracket for federal taxes and paying three percent in state income tax would earn a higher yield with a muni fund than with a taxable fund because the latter's tax-equivalent yield is higher.
Limiting your investment costs, including your tax costs, is one of the best ways to improve your take-home return, and Morningstar.com has lots of tools, articles, and analyses to help you do just that.
I'm Christine Benz. Thanks for tuning in.