(Money Magazine) -- Looking to improve your portfolio's performance? Still licking the wounds from tax day? Then it's time to kill two birds with one stone by making sure your investments are as minimally exposed to taxes as possible.
Over the past decade stock investors handed Uncle Sam an average of one percentage point a year in total returns, while bond investors forked over twice as much, according to Lipper -- and that was at a time when tax rates were relatively low and a balanced portfolio earned a modest 5%.
Even with better returns, though, you can substantially increase your performance just by cutting your tax losses.
Say you invest $15,000 a year for 30 years earning 7% annually. Lose two points of return a year to taxes, and you'll end up with around $1 million. Lose just 1 point, and you'll have $1.2 million -- a 20% boost to your returns.
Tax-efficient investing is actually simple for many of us, because the feds have created so many tax-advantaged accounts to nudge us to save more for retirement, college -- even health care.
If you're investing entirely through 401(k)s, IRAs, and 529s, "just maximize tax-deferred savings whether tax rates are high or low," says Joel Dickson, a tax specialist at Vanguard.
But if your investments are sown throughout different brokerage and retirement accounts, it's time to get organized. Make sure your investments are held in the right places so that you keep the most gains. ('They tried to deduct what?!')
Take these steps to cut your losses.
As you invest more and more outside your retirement plans, you must decide which assets to keep sheltered and which to pour into taxable accounts.
But this must be done in concert with your asset allocation plan. (Get the right asset allocation for you.)
For example, bonds generally expose you to more taxes than stocks, so it's best to hold them in a 401(k), says financial planner Gary Schatsky. But that doesn't mean you should invest more in bonds than stocks simply because more of your money is in your retirement accounts.
No matter what, use 401(k)s and IRAs to shield assets that expose you to the highest tax rates.
That means stock funds run by fast-trading managers who generate lots of short-term gains, and investments that throw off ordinary income -- like taxable bonds, REITs, and commodity ETFs that invest directly in gold.
If only 10% to 20% of your assets are in taxable accounts -- and if your investment strategy calls for it -- flow money into tax-free munis and tax-friendly I-bonds first.
Next go to index funds, where short-term gains are small and rare, and then dividend-paying stocks, where taxes are modest but due annually.
Planting investments in the right place is easy if you're starting from scratch. Figuring out how to shift assets already rooted in existing accounts can be a lot tougher. Here's the right way to transplant your holdings:
In your taxable account:
In your tax-deferred account:
Index funds aren't the only portfolios that can help minimize taxes. Some fund managers trade stocks infrequently, so they rarely trigger taxable gains. And they may routinely offset what little capital gains they generate with losses elsewhere in their portfolios to reduce the tax drag further.
As a result, these actively managed portfolios are perfectly suitable for a taxable account.
Will this make a difference to your returns? You bet.
Over the past decade the average gap between the pre- and after-tax returns of many blue-chip stock funds has been about one percentage point.
The average fund that invests in small companies has lost around 1.4 points in returns each year to taxes.
A manager who pays attention to tax liabilities can cut that loss by a third or more.
Bonus: Managers who trade infrequently tend to do better even before taxes.
To look up how tax-efficient your funds are, go to www.morningstar.com. Type in the ticker of your fund and then click the "Tax" tab. The page will then show you the pre- and after-tax performance of that fund since its inception.
Here are some solid actively managed funds that minimize taxes. See also our favorite funds in all categories -- the Money 70:
|Overnight Avg Rate||Latest||Change||Last Week|
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