Investing Advice

Tax-Efficient Funds

If your investments are in a tax-advantaged account such as an IRA or 401k, you want maximum return without any consideration for tax-impact. Go ahead and skip this section.

Tax efficient funds structure their holdings to produce as little taxable income as possible to their shareholders.

They may invest in tax-free municipal bonds, companies who do not pay dividends, or just keep a buy and hold strategy that produces little annual capital gains. Tax-efficient funds will have a low "turnover" of their stock holdings.

Obviously, funds with the words “tax-managed” in their names should be tax-efficient. But many funds with a low turnover rate of their holdings also achieve a low current tax liability for the fund holders.

Tax-efficient strategies include selling the highest-cost stocks first to limit the tax hit, and try to hang onto stocks for more than one year to get the lower capital gains tax rate. They also sell losers to offset the profit on gains.

Take advantage of them in a standard investment account, never in a tax-deferred IRA or 401k. There will be little tax to pay anyway.

Successful tax-efficient funds include the Calamos Growth Fund (5 year total tax hit of only 4.63%) and the Vanguard Tax-Managed Capital Appreciation (only .24% to pay taxes on over 5 years).

Here is an example of tax-efficiency:

Suppose you put $10,000 into a bond fund that yields 6% a year or $600. If you are in the 31% tax bracket, you will pay $186 in taxes.
If you were to put $10,000 into a stock fund that paid out 6% in capital gains this year, you would pay $120 in taxes since the $600 would be taxed at 20%.
If your $10,000 was invested in an index fund, which would have almost no distributions, and gained 6% in value this year, you could sell $600 worth of your shares of which only $36 (6%) is a taxable gain (as long as you've owned the fund for at least one year), the other $564 being a non-taxable withdrawal of principal. You would only owe $7.20 in taxes on the $600! There would also be some tax on any distribution of dividends.

Any money that is in your mutual fund upon your death will not be subject to any income tax - nothing. Your heirs will assume the shares with a new cost basis "stepped up" to the share value on the day that you die. Note that variable annuities do not qualify for a tax-free stepped up basis for your heirs.

Speaking of taxes, when you sell your fund shares, be sure not to pay taxes on reinvested gains and dividends twice. Only the gains from the current year will be taxable, since you should have paid the prior year’s gains already.

Other Stock Market Basics Topics:

  1. Mutual Fund Advantages
  2. History of Mutual Funds
  3. NAV
  4. Dollar Cost Averaging
  5. General advice about choosing a fund
  6. Mutual Fund Ratings
  7. Evaluating Mutual Fund Investment Risk
  8. Mutual Fund Share Classes
  9. Mutual Fund Fees
  10. The Mutual Fund Prospectus
  11. How important is the manager's length of experience?
  12. Why is the prospectus hard to understand?
  13. Mutual Fund Annual Report
  14. Comparing your fund to the competition
  15. Comparing funds on an after-tax basis
  16. Average Return on Investment
  17. How Not to Pick a Mutual Fund
  18. Cashing in Your Fund
  19. When to Sell Your Fund
  20. Mutual Funds and Asset Allocation
  21. When to get started with a mutual fund
  22. Types of Mutual Funds
  23. Value Stock Funds
  24. Growth Stock Funds
  25. Small and Micro-cap Stocks
  26. Mid Cap
  27. Large Cap Companies
  28. Income Stock Funds
  29. Mutual Fund Index
  30. Enhanced Index Funds
  31. Sector Mutual Funds
  32. Stock Market Sectors
  33. Defensive Stocks
  34. International Funds
  35. Real Estate Mutual Funds
  36. Socially Responsible Funds
  37. Balanced Funds
  38. Tax-Efficient Funds
  39. Bond Convertible Funds
  40. Junk Bond Funds
  41. Mixtures of stock types
  42. Closed End Funds
  43. Exchange Traded Funds (ETF’s)
  44. Stock Picking Strategy - Picking your own stocks?
  45. Fund names, and what they really invest in
  46. How to get started
  47. Where can I start investing with no money?

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