If you saw a stack of money lying on the ground, would you pick it up?
I certainly would. I think you would, too. But it's surprising how many investors routinely pass up free money by ignoring or downplaying the tax implications of their investment selections.
Paying attention to the types of investments you select for your taxable accounts is arguably even more important now. That's because many noted market prognosticators expect relatively modest returns for the foreseeable future in a so-called "new normal" environment. With potentially less money coming in, it makes sense to trim whatever investment costs you can, including the amount you'll owe to Uncle Sam.
Here are some of the key things to keep in mind when selecting investments for your taxable accounts.
1. Go straight to the source.
Perhaps the most simple and effective way to improve your portfolio's aftertax return is to consider a fund that's explicitly designed to minimize the tax collector's cut. Investors in all mutual funds have to pay taxes on any income or capital gains their mutual funds pay out, regardless of whether those payments are reinvested in the fund.
So-called tax-managed funds try to keep those income and capital gains to a bare minimum. Although their strategies vary, most such offerings actively offset any capital gains with losses elsewhere in their portfolios and shun investments that generate ordinary income, which is taxed at the highest rate.
The result is that a tax-managed fund with returns that look unimpressive on a pretax basis may look superb--or at least quite healthy--on an aftertax basis. Vanguard runs a terrific suite of tax-managed funds for nearly every role in your portfolio, while Eaton Vance runs solid tax-managed funds as well.
2. Consider a municipal-bond fund.
Municipal-bond funds are the original tax-managed funds. Whereas any interest you earn from a conventional bond fund is taxed at your own income-tax rate, you won't have to pay federal income tax on a municipal-bond fund's payout; you may also be able to skirt state income tax by buying a muni fund dedicated to your state's bonds.
Although you might think municipal bonds are a tax dodge geared toward the super-rich, you needn't be in the highest tax bracket to benefit from opting for a muni fund. To determine whether you're better off in a taxable-bond fund or a municipal-bond offering, you can calculate the Tax-Equivalent Yield using the formula, Tax-equivalent yield = Tax-free yield/(1-your tax bracket). By plugging in the current yields of taxable- and municipal-bond funds you're considering, along with your own income-tax rate, you can quickly see how much the taxable-bond fund would have to yield to outstrip the muni fund's payout once taxes are taken into account.
There is, however, one notable caveat to bear in mind when venturing into municipal bonds. Although I noted that income from muni bonds generally isn't subject to federal income tax, the payouts of certain municipal bonds are subject to the Alternative Minimum Tax. To avoid muni funds holding AMT-subject bonds, look for those with "Tax-Free" or "Tax-Exempt" in their names. Such funds are required to keep 80% or more of their assets in bonds not subject to the AMT.
3. Be picky about investment approach.
Maybe you have a hard time getting excited by the available tax-managed or municipal-bond funds. If you're venturing into funds that aren't explicitly geared toward keeping your tax bill down, you should know which fund types will tend to be tax-efficient and which will not.
When buying stock funds for your taxable account, you'll generally want to focus on those that use low-turnover approaches, such as most large-cap index funds. These passively managed funds aim to match the returns of a market index and make portfolio changes only when the index constituents change. Actively managed funds, on the other hand, may follow a faster-trading strategy as the manager moves in and out of positions seeking to beat the market, potentially triggering lots of taxable gains.
Whether you're seeking passive or actively managed funds, look for those with turnover rates of less than 25% a year, if possible. (A turnover rate of 25% indicates that a manager trades the entire portfolio every four years.) Higher-turnover funds tend to generate lots of capital gains, some of them short-term. Capital gains payouts are never welcome for taxable investors, but short-term gains are particularly harmful because they're taxed at your ordinary income-tax rate.
You'll also want to concentrate your search on those funds that generate returns via stock-price appreciation rather than income from bonds or other securities. That's because income from bonds and real estate investment trusts is taxed at the highest rate--your ordinary income-tax rate. (Stock dividends are less worrisome for taxable investors, because they're currently taxed at your capital gains rate--though that advantage is scheduled to expire at the end of 2010.) If you're inclined to buy a heavy-income generator--such as a high-yield bond, real estate, or even a balanced fund--consider stashing it in a tax-advantaged account such as your IRA or 401(k) plan.
4. Pay attention to history.
To help identify those funds that have historically done a good job of keeping the tax collector at bay or to see how tax-friendly your current holdings are, you'll want to pay close attention to the Tax section that we supply on each Morningstar.com Fund Report.
By eyeballing a fund's aftertax return and rankings, you'll be able to see how much of that offering's raw return an investor in the highest tax bracket would have been able to pocket once taxes were taken into account. In some cases, the difference can be meaningful. For example, Schneider Small Cap Value's (SCMVX) 10-year average pretax return of 11.7% lands the fund in the top 12% of its category, but after accounting for the tax bite, its average return and category percent rank drop to 8.4% and 30%, respectively.
In the same Tax section, Morningstar also provides a tax-cost ratio for each fund for each time period. You can use the tax-cost ratio much as you do a fund expense ratio, and you can add the tax-cost ratio to your fund's expense ratio to estimate that offering's total costs for investors in the highest tax bracket.
5. Look to the future.
While tax-adjusted returns and tax-cost ratios will show you how tax-efficient a fund has been in the past, they won't tell you everything you need to know about whether a fund is likely to be a good bet for a taxable account in the years ahead. That's where Morningstar's potential capital gains exposure figure (also available on the Fund Report Tax tab) comes in. This statistic shows you what percentage of a fund's assets is made up of realized or unrealized gains or losses. For example, if a manager bought a stock at $10 five years ago and it's now selling for $110, the portfolio has $100 in unrealized appreciation per share. If he or she were to sell the stock tomorrow, shareholders would have to pay capital gains tax on that $100. Funds can also have negative potential capital gains exposure, meaning that the fund has losses on its books that it can use to offset future gains.
Morningstar Investment Research Center users can put several of these statistics together to screen for funds that have been tax-efficient in the past and could be good bets for taxable accounts in the future, too. For an example, visit the Fund Screener page and select Aftertax Stars from the Morningstar Screens menu.
6. Venture beyond mutual funds.
Although I've focused largely on mutual funds so far, your taxable account is a great place to hold individual stocks if you're inclined to do so, particularly if you trade infrequently. As I've noted, with a mutual fund you're on the hook for taxes on capital gains payouts regardless of whether you've sold any shares. If you own individual stocks, on the other hand, you don't have to pay capital gains tax until you yourself sell a share and lock in a gain.
Exchange-traded funds (ETFs) can also prove a tax-efficient alternative to mutual funds. ETFs sell on an exchange, meaning most trading takes place between shareholders. Individuals cannot redeem their shares for cash directly from the fund company. Thus, the fund manager doesn't have to meet redemptions, so he or she won't be forced to sell shares to raise cash, potentially realizing a capital gain. Furthermore, the large institutional shareholders that are permitted to redeem ETF shares directly from the fund company do not receive cash in exchange for their shares. Instead, when they redeem, they are given a basket of the stocks held in the ETF's portfolio. This allows the ETF to continually hand off its lowest-cost-basis shares to redeeming institutions, helping ETFs keep their potential capital gains exposure much lower than it would otherwise be.
7. Beware of generalizations.
Although ETFs are generally more tax-efficient than conventional mutual funds, there have been a handful of instances when ETFs have made sizable capital gains distributions. And as mentioned above, index funds are also frequently cited as being more tax-efficient than actively managed funds, but that's not necessarily so, either. Index funds that track benchmarks that frequently make substantive changes to their holdings--notably, many small-cap index funds--may be no better for your taxable account than will actively managed funds.
Morningstar Investment Research Center is great tool for new and veteran investors. It's chock full of unbiased analyst reports, tools for evaluating your portfolio, and lessons on how to invest. The best part is that it's free to all valid library cardholders! Begin now or learn more.
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