More Ways to Reduce Uncle Sam's Take

Well, it's that time of year again. With tax day looming, investors are coming to terms with the tax consequences of their investment decisions. The pain is likely widespread: According to fund industry data, roughly two thirds of mutual fund assets are kept in taxable accounts. And last year was a banner year for capital gains payouts, so last year could've been very costly from a tax perspective.

Ignoring the impact of taxes on decision-making is a huge mistake. In his speech "The Relentless Rules of Humble Arithmetic," Vanguard founder Jack Bogle notes that the average equity mutual fund loses about 2 percentage points of its average annual return to taxes.

Why are mutual funds such a potential tax headache? By law, mutual funds are required to pass all income and realized profits on investments along to shareholders through income and capital gains distributions. If you're investing through a taxable account, you'll have to pay taxes on those distributions. Short-term gains are taxed at the higher ordinary-income rate, as is income from taxable bonds, commodities, and real estate investment trusts. Meanwhile, long-term gains and stock dividends are generally taxed at the 15% rate. Thus, funds that trade a lot, and thus generate heavy short-term gains, generally aren't tax-efficient. The same is true for income-heavy offerings, such as bond or REIT funds.

That's not to say you shouldn't have fast-trading funds in your portfolio or that you should avoid bonds and REITs. It just might make sense to keep them in tax-sheltered vehicles such as your 401(k) or in an IRA.

Investing outside of a 401(k) or IRA means you'll have to be mindful of every move you make from a tax perspective. While it may be too late to do anything to reduce your tax liabilities for tax year 2007, here are some tips for keeping the tax man at bay in the years to come. (For a longer list, check out Christine Benz's article on managing your tax hit.)

Invest in Tax-Managed Funds
Tax-managed funds are explicitly designed to keep taxable distributions to a bare minimum. These funds use a variety of strategies to ward off the tax collector. Typically, they keep turnover low. By holding stocks for a long time, they minimize the possibility of taxable gains. Not all trading is verboten, however. They'll sell losing stocks to offset winners elsewhere in the portfolio. These funds have historically avoided dividend-paying stocks, though that's changing a bit now that more companies are paying dividends and dividends are taxed just like long-term capital gains (prior to 2004, dividend income was taxed at an investors' highest marginal tax rate).

Given the toll that taxes have on returns, it's surprising that there aren't more tax-managed funds. Still, there's enough from which to choose. Do-it-yourselfers should check out Vanguard's tax-managed lineup, which has not only limited shareholders' tax bills but also boasts peer-beating long-term returns and low costs.  Vanguard Tax-Managed Growth & Income  offers a tax-friendly spin on the S&P 500 Index, for instance, while  Vanguard Tax-Managed Balanced (VTMFX) pairs stocks with tax-free municipal bonds. Eaton Vance offers a suite of tax-managed advisor-sold funds, including solid options such as  Eaton Vance Tax-Managed Value (EATVX).

Look for Closet Tax-Managed Funds
Even without an explicit mandate, many fund managers, such as  Oakmark's (OAKMX) Bill Nygren and  Third Avenue Value's (TAVFX) Marty Whitman, run their portfolios with an eye toward tax efficiency. Or at least they employ a low-turnover strategy that has the beneficial side effect of keeping taxable distributions at bay.  Davis NY Venture (NYVTX) managers Chris Davis (no relation to this author) and Ken Feinberg buy great companies when they're cheap and hang on to them for years--turnover clocked a miniscule 5% last year. That fund has not only delivered great long-term returns, but shareholders have sacrificed little of it to taxes.

You can find that gap--known as Morningstar's tax-cost ratio--under the Tax Analysis tab of every fund's report (Davis NY Venture's tax analysis is here). Think of the tax-cost ratio just as you would a fund's expense ratio. The expense ratio represents what percentage of your return is siphoned to pay for the fund's expenses. Similarly, the tax-cost ratio signifies what percentage of a fund's return has historically gone to the Feds. It's certainly not a perfect measure--a fund that's lost a lot of money will probably have a very low tax-cost ratio--but, generally speaking, the lower the tax-cost ratio, the better.

Don't Forget about Index Funds
There's more to index funds' appeal beyond their often low costs and generally category-beating returns. Index fund managers tend to trade infrequently, which typically results in terrific tax efficiency.  Vanguard Total Stock Market Index's (VTSMX) turnover is just 4% a year, and its 10-year tax-cost ratio is just 0.41% (for its large-blend category, the average is 1.17%). Still, not all index funds are as tax-friendly. The makeup of small-cap indexes fluctuates much more as successful companies graduate to mid-cap indexes. As a result, small-cap index funds have been much less tax-efficient.

Think about ETFs
Exchange-traded funds enjoy the same tax benefits as conventional index funds. That's because ETFs are simply index mutual funds, albeit ones that trade on stock exchanges all day long (traditional mutual funds, by contrast, are bought directly from a fund company and are priced once a day).

In theory, at least, ETFs have some tax advantages over index mutual funds. ETF managers don't ever have to sell holdings to deal with shareholder redemptions (ETF investors trade shares among themselves, not with the fund, and the managers can satisfy large redemptions in-kind with shares of stock instead of cash). That makes the possibility of capital gains payouts less likely. Still, it's worth noting that  Vanguard 500 Index  (VFINX) has actually been more tax-efficient than its ETF rivals,  SPDR (SPY) and  iShares S&P 500 Index (IVV). Of course, ETFs aren't universally tax-efficient. Small-cap ETFs are just as flawed from a tax perspective as small-cap index funds, for example.

Make Other Investors' Losses Your Gain
The IRS allows mutual funds to carry forward, or keep, losses on their books for seven years, which it can use to neutralize gains elsewhere in the portfolio. Funds with large tax-loss carryforwards can use them to stave off taxable capital gains for some time. To identify such funds, look at its potential capital gains exposure on the Tax Analysis tab of its report.  AIM Dynamic's  potential capital gains exposure clocks in at a negative 110% of assets. What that means is that the sum of the fund's past losses are more than 10% greater than the total value of its assets.

Of course, that also means that the fund has lost a heck of a lot of money for shareholders. Funds with big tax-loss carryforwards may also be lousy funds. After all, Jacob Internet's  (JAMFX) potential capital gains exposure is hugely negative thanks to the enormous losses it suffered in the bear market, but we wouldn't touch it with a long stick. AIM Dynamic was no champ in the bear market either, but a new manager took charge in 2004 and ditched the prior management's favorites, which were well underwater. With the fund now charting a more moderate course, we like its prospects. Meanwhile, shareholders probably won't have to pay taxes on capital gains for years to come.

Houseclean Your Own Portfolio
Individuals, too, can use past losses to counteract winners elsewhere in their portfolios. Don't sell an otherwise-strong fund just to generate a loss, but if you were thinking about selling anyway, do so before the end of the year. You'll be able to deduct as much as $3,000 in capital losses against your income. You can read about how to harvest your portfolio's gains and losses here.

Conclusion
Tax considerations are important, but don't let them cloud the big picture. If your objective is to evade Uncle Sam, then you're letting the tail wag the dog. Look for superior funds--those with seasoned managements, strong long-term returns, and low expenses--and then think about whether they'll be tax-efficient or not. Remember, your goal isn't just to avoid taxes but, rather, to earn the best aftertax returns.