If you hold funds inside a tax-advantaged retirement account like a 401(K) or an IRA, you don't have to worry much about capital gains taxes. But for the rest of your portfolio, those taxes can take a not-insignificant bite out of your profits every year. In this segment of Motley Fool Answers, Alison Southwick and Robert Brokamp dig into the ways some mutual funds can -- and do -- help you avoid some of those tax burdens.
A full transcript follows the video.

This podcast was recorded on Oct. 4, 2016.

Alison Southwick: It's time for "Answers, Answers." Barry writes: "Hi, Fools. My broker is recommending I get into a tax-managed fund. I certainly understand the idea of favoring capital gains over dividends to decrease current taxes." Oh, I need to unpack that sentence here. I currently understand the idea of favoring capital gains over dividends to decrease current taxes.

Robert Brokamp: Right, because you pay taxes on your dividends each and every year, but capital gains, you can defer them...

Southwick: Oh, until you sell.

Brokamp: ... until you sell. There you go.

Southwick: "... but I'm not clear on how stocks might be swapped in these funds to maximize the tax advantage. Can you please explain how these funds work?" Yeah, explain how these funds work!

Brokamp: Well, Barry, it's a really good question. First of all, we're really talking about mutual funds that you hold outside of your IRA and 401(k). If you have it in those accounts, you don't have to worry about any of these tax consequences.

But there's a funky thing about the taxation of mutual funds, and that is even if you're holding onto the fund and you're not selling it, you are going to be held accountable for any capital gains that are generated when the manager buys and sells a fund inside the fund. So let's say you hold a fund. It bought a stock three years ago for $50. It sells it today for $100. That's a $50 capital gain per share that has to be distributed to the owners of the fund.

The crazy thing about that is if you just bought the fund yesterday, you're still going to be liable for that $50-per-share capital gain. These gains have to be distributed once a year. They tend to happen toward the end of the year, so if you're thinking of buying a fund in a taxable account, now may not be the best time of year to do it. You can call the fund company and say, "Hey, I want to buy the fund. Does it look like you're going to make any capital gains distributions?" And they'll tell you. So if you have a fund that is outside of an IRA or a 401(k), it makes sense to look at the tax efficiency of the fund.

What these tax-managed funds will do, first of all, as you point out, they might favor stocks that don't pay dividends over ones that do. Or if they buy a stock that has a dividend, they want to make sure that it's a qualified dividend. Qualifying dividends are taxed at lower rates than regular dividends. That involves the type of company.

It also involves making sure that you hold onto that stock for a while. They might be more inclined to hold onto the stock longer. For capital gains, a short-term gain is one that you sell within a year, and you're going to pay a higher tax rate than if it's a long-term capital gain, so that manager is ideally going to hold onto the stock longer.

Just like individuals, mutual funds can do tax-loss harvesting, so they can do losses to offset the gains. A tax-managed fund will be more likely to do something like that. And also if the fund involves investments in any kinds of bonds, it might choose bonds that have tax breaks like municipals, Treasuries, things like that.

Now, one thing you should know, though, is that index funds and ETFs are already pretty tax efficient, and they have lower costs than the average tax-managed fund. You might want to ask your broker, "Is this really the best fund for me, or should I just get an index fund?"

And one way to determine the tax efficiency of a fund is to look it up on Morningstar. You'll see a little button there called "taxes." And they have something called a tax cost ratio, which is basically an estimate of how much of your return is lost to taxes. Look at this tax-managed fund that the broker is recommending, compare it to a relevant index fund, and see. Maybe an index fund would be a better bet for you.

Southwick: There you go, Barry. Your advisor says, "Go here," and you go back and you're like, "No!"

Brokamp: That's right.

Southwick: Because I went to Morningstar, I hit a button, and boom!

Brokamp: I should be advising you!

Southwick: Yeah!

Brokamp: And then ask for a commission for that advice.

Southwick: We can get a kickback.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.