(MONEY Magazine) – Death and taxes are both certain," an anonymous wag once wrote, "but death isn't annual." Considering that this quip was one of the funniest that I could find among the 298 witticisms listed at Tax Analyst Online (www.tax.org/quotes/quotations.htm), I think we can all agree that taxes are no laughing matter. In fact, when it comes to their effect on your investment returns, crying might be the more appropriate reaction. Take mutual funds. "The return you get after taxes is often nowhere near the return you see reported," says Vanguard fund taxation specialist Joel Dickson. He estimates that over the past decade, domestic stock funds have lost 2.5 percentage points of return a year on average to taxes--effectively reducing annual returns by more than 15%. How? Much of the problem comes from managers' frenetic trading, which generates taxable capital gains. I guess this is what T.S. Eliot had in mind when he called April the cruelest month.

In honor of the looming tax-filing deadline, this column will deal with ways to keep the Internal Revenue Service's hands off your investment gains. No, I'm not going to tell you to run your brokerage account from a post office box in Luxembourg. That would be impractical (and wrong, of course). Besides, radical moves to avoid taxes often lead to lousy investment decisions--witness investors who got burned in fee-heavy limited partnerships in the 1980s.

So I'm merely going to suggest four tax-wise strategies that are a) perfectly legal and b) so simple even investment pros can understand them.

My tips won't help you with 1999's taxes. But if you take advantage of the options below--as well as others you're already familiar with, such as 401(k)s and IRAs--you can limit how much of your gains go to the U.S. Treasury in the future.

Put munis in your mix. If you own bonds in your portfolio--and I believe most diversified portfolios should contain at least a handful of bonds--then tax-free municipals are probably a better choice than taxable alternatives like Treasuries and corporates. The reason: Munis give you a shot at higher re-turns once you factor in their tax savings. According to fund firm T. Rowe Price, an investor in the 31% tax bracket would have earned returns equivalent to an annualized 10.3% in munis for the 10 years ended Sept. 30, 1999, vs. 8.5% in corporates and 7.9% in Treasuries. Investors in higher brackets would have benefited even more.

There's no guarantee that munis will continue to outperform, but their prospects look good, in part because budget surpluses will probably push the Treasury to shrink the supply of Treasury bonds. All else being equal, a dwindling supply of Treasuries would hold down Treasury yields, making munis more attractive. In order to find out whether you should be in munis or taxable bonds, check out the worksheet below.

Play the indexes. You've no doubt heard index funds extolled for their superior long-term performance. But you should also consider them for their high "tax efficiency." That's a fancy way of saying that index fund shareholders keep a higher percentage of their gains after paying taxes than shareholders in regular stock funds do.

What makes index funds efficient is their low portfolio turnover. Most stock fund managers are constantly trading securities, typically replacing 80% or more of their holdings each year. When these trades are profitable, they create realized (read: taxable) short- and long-term capital gains. By law, funds must distribute these gains to shareholders, who in turn pay taxes at a rate of up to 39.6% for short-term gains and as much as 20% for long-term gains. But since index funds engage in the "passive" strategy of simply buying and holding the stocks of whichever index they follow, they have much lower turnover than actively managed funds--often 5% or lower annually. This translates to fewer realized capital gains and smaller taxable distributions to shareholders. (Of course, index funds must also pass along dividend payments, if any, but there's not much they can do about that.)

In fact, there are only two reasons an index fund might create capital gains: The manager has to sell stock to raise cash for investors redeeming their shares, or the fund's portfolio requires rebalancing to reflect a change in the underlying index. (In January, for example, semiconductor firm Conexant Systems was added to Standard & Poor's 500-stock index and utility Consolidated Natural Gas was dropped.) But even in the case of departing shareholders, funds can employ techniques to keep taxable distributions down. Vanguard 500 Index fund manager Gus Sauter, for example, uses "hifo" or high-in-first-out accounting, which essentially means selling shares with the highest cost to minimize realized gains and distributions. So far, taxable distributions from the fund, which tracks the S&P 500, have been minimal. In 1999, taxable capital gains and dividend distributions to shareholders accounted for less than three percentage points of the fund's 21.1% return, which means the overwhelming majority of the return came in the form of appreciation in the fund's share price. That is "a good thing," as Martha Stewart might say, since appreciation in fund shares is taxed only if you sell.

Some doomsayers warn that a mass exodus from index funds could force managers to unload lots of stock, sticking shareholders with huge distributions. While that's a possibility for all sorts of funds, I don't think it's a big enough danger to lose sleep over.

You can also get the tax efficiency of index funds in a relatively new type of investment that are known as ETFs, or exchange-traded funds. The actual mechanics of ETFs are too complex and boring to go into here, but they are basically indexes that you can buy and sell like any other stock. You should have no trouble finding one to match your investing style. For example, State Street Global Advisors' "Spiders" (SPDRs, or Standard & Poor's Depositary Receipts) track the S&P 500 as well as nine S&P 500 sectors, ranging from consumer services to technology.

By the second half of this year, Barclays Global Investors plans to issue its own line of ETFs called iShares, which will initially include 36 portfolios that track a slew of indexes from Standard & Poor's, Dow Jones & Co. and the Frank Russell Co. You can even invest in 17 foreign markets by buying index portfolios known as WEBS (World Equity Benchmark Shares), which are managed by Barclays. If that's not enough, State Street plans to introduce nine more ETFs, while Barclays expects to launch 15 more iShare portfolios, plus 11 more WEBS. Frankly, I think this is more indexing power than most people need, but I suppose it's comforting to know you can track the Dow Jones U.S. basic materials sector index if you want to. (For more on ETFs, see "The New Force in Funds" in the February 2000 issue of MONEY or go to www.money.com/barclays.)

Capitalize on losses. While index funds' tax efficiency stems naturally from their low turnover, another breed of funds--tax-managed funds--purposely try to minimize, if not eliminate, taxable distributions. To accomplish this, managers rely on a few specific strategies. First, they tend to emphasize stocks with no or low yields, which reduces dividend income. Second, they buy and hold. This way, the fund has fewer realized gains, and those it has tend to be long term, which qualifies them for the lowest tax rates. Finally, managers will occasionally sell some stocks for losses, which they can later offset against gains in other stocks. "Those losses provide a tax shield that can be used to shelter future gains," says Donald Peters, who manages T. Rowe Price Tax-Efficient Growth and co-manages Tax-Efficient Balanced, a fund that invests in a roughly fifty-fifty mix of stocks and muni bonds (T. Rowe Price: 800-638-5660).

If you like the idea of indexing but also want the benefits of a tax-managed fund, you can find both those qualities rolled into one in what I suppose you could call tax-managed index funds, although, thankfully, nobody does. The Schwab 1000 fund (800-435-4000), for example, tracks a Schwab index of the 1,000 largest U.S. companies. But in an effort to avoid taxable distributions, manager Geri Hom also employs proprietary software to harvest losses in certain stocks that can cancel realized gains in others. Gus Sauter employs similar strategies at Vanguard's stable of tax-managed funds. Vanguard's Tax-Managed Growth & Income, for example, follows the S&P 500 index, much as the Vanguard 500 Index fund does, although the tax-managed version occasionally deviates from the index to take losses in some stocks (Vanguard: 800-851-4999). So far, tax-managed funds have pretty much lived up to their promise of limiting taxable distributions.

Build your own tax shelter. I love this last strategy because it's simple yet effective--and it goes against the prevailing putative wisdom that frequent trading is the route to success. All you do is buy stocks that have superior long-term prospects and pay little or no dividends--then hang on to them unless their prospects sour or you need the money. As a practical matter, this strategy involves buying companies with fast-growing earnings, since they're least likely to burden you with taxable dividends.

Following this strategy accomplishes two things. First, you get tax-deferred compounding of gains. "You're earning a rate of return on money you otherwise would have sent to Uncle Sam," says Neil Wolfson, national partner in charge of investment consulting at KPMG LLP. Second, by holding a stock longer than a year before selling, any gain is taxed at the maximum long-term capital-gains rate of 20% rather than at ordinary income rates of up to 39.6% (not including state taxes). This combination of deferral and lower rates does not eliminate taxes, but as the chart on page 71 shows, it dramatically reduces the IRS' take.

One more thing: Bequeath a stock or fund to an heir, and appreciation in the share price during your lifetime escapes income taxes (although confiscatory estate taxes could still apply). So taxes may not be so certain. We've still got to work on that death thing, though.

Senior editor Walter Updegrave is the author of Investing for the Financially Challenged (Warner Books). You can reach him at investing101@moneymail.com.