Watch Out for Tax Drag on Investments

Note: This video is part of Morningstar's Tax Relief Week special report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

Many investors assume that paying taxes on their investment gains is simply the cost of doing business. They might assume that trying to reduce their investment-related taxes is unpatriotic, or something only really rich people care about. But taxes have the potential to reduce your investment returns, so they're worth paying attention to regardless of your income level.

There are a few key ways for individual investors to reduce the drag of taxes on their portfolios. The first is simply to take advantage of any and all of the tax-sheltered investment vehicles you have access to. For most households, that means company retirement plans like 401(k)s as well as IRAs. Families saving for college will want to take advantage of 529s, and people enrolled in high-deductible healthcare plans should use health savings accounts.

My second tip is to hold your investments in a variety of account types with varying tax treatments. It's really hard to guess whether your tax bracket today is higher or lower than it will be when you pull your money out in the future. Accumulating assets in multiple silos helps you hedge your bets.

Finally, to the extent you hold any non-tax-advantaged assets, pay close attention to the types of investments you hold within them. Equity index funds and exchange-traded funds are often tax-efficient choices, as are municipal bonds and bond funds.

Thanks for watching. I'm Christine Benz for Morningstar.com.