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Five Great Funds for Tax-Savvy Investors

Boost your aftertax returns with these easy fund-picking strategies.

If you're choosing investments for a taxable account, one of the easiest ways to boost your returns is to factor taxes into your selection process. In September I warned that capital gains distributions would be making a comeback for some types of funds, making taxes a particularly pertinent issue.

Today, rather than looking at potential potholes, I'll outline ways to find funds that should provide pleasing aftertax returns for many years to come.

Consider a Tax-Managed Fund
I'm always surprised when reporters ask me if tax-managed funds are gimmicks. Taxes are very real and so is their effect on fund investors' returns. Most stock-fund managers pay little heed to taxes, so making an effort to invest with one who does will very likely pay off.

Tax-managed funds have consistently put up above-average aftertax returns. These funds' most important tactic is realizing losses to offset gains so as to minimize capital gains distributions. Some funds are passive, indexlike vehicles that have the advantage of having low turnover and holding a wide array of stocks, which improves the odds of having some tax losses to harvest. Others are active funds, which are more likely to make the occasional distribution, but should still deliver decent aftertax returns.

One of the best passive examples is  Vanguard Tax-Managed Growth & Income . The fund hasn't yet made a capital gains distribution since it was launched in 1994, and its five-year annualized aftertax returns are in the large-blend category's top third. On the active side is  Oakmark Fund (OAKMX), which Bill Nygren runs in a rather bold value style. It will make an occasional distribution, but Nygren does keep taxes in mind, and the fund still has some tax-loss carryforwards that should stand it in good stead if the current rally has legs. (See more on carryforwards below.)

Buy a Municipal-Bond Fund
If you're in the top tax bracket, a muni fund might be a better option for you. You can test that assumption with our bond calculator, which can help you determine if you're better off investing in taxable or municipal bonds using a tax-equivalent yield function.

Buying a muni fund is a little different from buying a taxable fund. Munis are less liquid and less researched than taxable bonds, so you should look for a fund that's nicely diversified and doesn't take on a lot of credit risk. A couple of weeks ago, I had a chance to visit Fidelity's muni group in New Hampshire and came away impressed. Fidelity's strengths have always been investment technology and issue-selection, and its muni group has done a great job of harnessing both.  Fidelity Spartan Intermediate Municipal Income (FLTMX) is proof of how well that strategy has worked.

Look for a Fund with a Built-In Tax Loss
If a fund has losses on the books, its shareholders will enjoy a free ride until it works those losses off the books or those losses expire.

Scores of growth funds have big losses from the bear market even after this year's rally. It's harder to find a good small-cap fund with a built-in loss, however. One of the few is  FPA Paramount , which has a big loss built up by previous management. Current managers Eric Ende and Steve Geist have built a strong record at another FPA fund, and we're optimistic they can repeat their success here.

Get Dividend Exposure in a Moderate-Allocation Fund
Because of a quirk in tax codes, you can enjoy better aftertax returns when a dividend-focused portfolio is wedded to a bond portfolio than you would from buying each portfolio separately.

The reason is that funds pay their expenses with yield, and they get to designate which sources are paying the expense ratio and which should be distributed to shareholders. (Click here to learn more about how the recent dividend-tax cut can offer special advantages to fund investors.) Thus, a balanced fund can send all of its stock-dividend income, which is taxed at a lower rate than bond dividends, to shareholders and use bond income to pay off expenses. To begin searching for a good moderate-allocation offering,  screen for low-cost, value-oriented funds. One of my favorites is  Dodge & Cox Balanced (DODBX).

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