Are you giving up too many of your investing dollars to Uncle Sam? Mutual funds boost your tax bill by passing on dividends and capital gains earned on the sale of stocks or bonds. This shouldn't worry investors who hold funds through 401(k)'s or IRAs, since those accounts are already sheltered from taxes. But for those with taxable accounts, here are four types of funds that help keep taxes to a minimum:
Municipal bond funds. Issued by states, cities, counties, and assorted agencies, muni bonds are exempt from federal income tax—which makes them popular among high-income investors. Although they typically pay out less than treasuries or other taxable bonds, munis can provide higher after-tax yields for investors in the 28 percent tax bracket and above. Sometimes they work for investors of all tax brackets. Munis may also have triple-tax-free status, if they're exempt from taxes at the municipal, state, and federal levels.
Index funds. Since these funds passively track an index, they tend not to trade excessively. And fewer trades mean that fewer capital gains are passed along to shareholders, lowering their tax bill. Vanguard offers a lineup of index funds that aim to minimize the tax bite, including Tax Managed Balanced, which is made up of roughly half stocks (mostly the type that pay no dividends) and half munis.
Tax-managed funds. In many cases, these funds tout their strategy with "tax-managed" in the name (see the above Vanguard funds). Since the mid-1990s, the tax-managed universe has grown to include dozens of funds—enough to create an entire portfolio, says Tom Roseen, senior research analyst at Lipper. "With these funds, you have managers focused on mitigating tax drag," he says. They do this using strategies such as avoiding dividend-paying stocks and a technique called tax-loss harvesting, in which managers may purposefully sell stocks for losses so they can offset gains in the future (thus reducing or eliminating taxable distributions).
Other funds don't brag about their ability to minimize taxes. Lipper produced a list of no-load, diversified stock funds ranked by tax efficiency for U.S. News. They include Fidelity Leveraged Company Stock, Bridgeway Aggressive Investors 2, Amana Income, Kinetics Paradigm, and Janus Enterprise. These funds all ranked in the top 10 percent of their categories on a three-year basis.
Exchange-traded funds. Since ETFs behave like index funds, they also tend to limit turnover. And while mutual fund investors pay taxes on their funds' income or gains before they sell the fund, ETF investors can delay paying taxes until they sell. Deferring taxes is helpful because it allows you to keep your money invested and growing.