Consider ETFs. Exchange-traded funds have been gaining popularity among investors, and not only because they tend to have lower annual fees than mutual funds. By design, ETFs are generally more tax-efficient as well.
Most ETFs track indices, and because much of their day-to-day trading occurs only between shareholders and doesn't affect the underlying securities, turnover and capital gains remain relatively low. That paradigm is much different than the scenario with mutual funds, in which fund managers might have to sell underlying securities (sometimes at a loss, sometimes at a gain) in order to satisfy shareholder redemptions.
"Let's say you own an ETF and want to sell it. You go into your Schwab account and you sell the ETF shares to another shareholder," says Matt Hougan, president of ETF analytics at IndexUniverse. "There's no contact back to the ETF company. When investors sell, it doesn't force the ETF company to sell securities and incur capital gains."
Hougan cites iShares, the largest family of ETFs, as an example. According to its website, in 2010 iShares made capital gains distributions for only five ETFs (all bond funds) out of the 218 funds the company offers. "Equity ETFs, by and large, never pay capital gains distributions," Hougan adds.
Try a tax-managed fund. Some mutual funds aim to limit shareholders' tax burden by using a variety of active-management strategies to minimize taxes. These funds tend to have long-term outlooks and harvest losses to offset gains to avoid capital gains taxes. They also tend to avoid dividend-paying stocks.
Davis recommends Vanguard Tax-Managed Growth and Income (symbol VTGIX), which mimics the S&P 500, but pays special attention to tax considerations. For instance, although the fund has similar sector and stock weightings as the S&P 500, management might sell certain positions at a loss to offset gains from better-performing holdings. As a result, the fund's weightings vary slightly from its benchmark.
Davis also likes Vanguard Tax-Managed Capital Appreciation (VMCAX), which mimics the Russell 1000 index. A feather in the cap of this tax-managed fund: It has never distributed a capital gain in its 16-year history, according to Morningstar.
Wait to buy. Most funds dole out capital gains distributions late in the year, so avoid picking up a fund if management plans to pay out a distribution. That way, you can avoid paying taxes on gains you haven't yet participated in. Also, it's helpful to know a little bit about the balance sheet of a prospective fund. If it has significant losses to carry forward to offset gains in the future, it could be tax-efficient going forward.