Reading an article about investing tax strategies might feel a bit like being told to eat a bowl of broccoli, and then being forced to floss afterward.
But good investors should really be mindful of taxes all year long. With that in mind, I've tried to make this as quick and simple as possible. For our three tax tips, I interviewed veteran financial planner Norm Mindel, author of the new book Wealth Management in the New Economy.
1. Look for funds with low turnover
Mutual funds that turn over their holdings rapidly tend to be tax-inefficient. It's not uncommon to see a portfolio turnover ratio of 80% to 120% a year. "That's going to create a lot of capital gains distributions and a lot of drag," Mindel said in an interview. "Compare that with an ETF or an index fund with a low turnover around 15% to 20%." For example, the SPDRs (NYSE: SPY) ETF and Vanguard 500 Index (VFINX) have turnover ratios of 7% and 12%, respectively.
Morningstar offers a clear way to view the turnover ratios for any fund. Index funds in particular are known for low turnover ratios, but if you're looking for actively managed funds, be sure you're aware of a fund's turnover. The growth-oriented CGM Focus (CGMFX), for example, sports a turnover ratio of over 450%! Manager Ken Heebner has a long record of success, but prospective investors should know that his bold, often quick bets could lead to higher-than-average capital gains distributions. Which segues nicely to tip No. 2 ...
2. Put the right investments in their place
Place tax-efficient investments in taxable accounts and tax-inefficient investments in tax-deferred accounts, such as an IRA or 401(k). A tax-efficient investment is one for which an investor pays low taxes -- think of a low- or no-yield stock like chip maker Atheros Communications (Nasdaq: ATHR). Shareholders of Atheros will only have to pay taxes on long-term capital gains when they sell their stock. Mindel suggests that investors keep the low turnover funds or ETFs in taxable accounts.
A tax-inefficient investment is one on which an investor would pay higher taxes. High-yielding stocks -- those with hefty dividends like Verizon (NYSE: VZ) or AT&T (NYSE: T), which both yield a little over 6% -- are best kept in tax-deferred accounts until retirement because in those accounts, the dividends would be able to grow without being taxed. High-turnover funds like CGM Focus are also best for a tax-deferred account.
Mindel says that there are other asset classes that aren't tax efficient that you should still own -- such as REITs, global bond funds, and bond funds that invest in inflation-indexed TIPS. Those should also be kept in tax-deferred accounts.
If you want to invest some of your taxable account in bonds and you're in a high tax bracket, Mindel suggests considering municipal bonds -- those issued by local governments -- because they're typically exempt from federal taxes.
3. Rebalance
Mindel says investors need to adhere to a disciplined asset-allocation policy of capturing the gains of winning asset classes by selling them and buying the losing asset classes. That isn't what most people do, though. "If something did well, they buy more instead of selling the winner and buying the loser," said Mindel. He advises prioritizing rebalancing within tax-deferred accounts like IRAs and 401(k)s.
Mindel also says that too many investors focus solely on taxes. "They're not the No. 1 important thing," he said. "The most important thing is to rebalance. And if you do incur some taxes along the way, so be it."
Mindel points to the Internet bubble as an example. "People refused to capture the gains. The market corrected and then people didn't want to sell because they thought it would come back. ... If there's anything a professional advisor does, they are the unemotional person on the sidelines saying take the losses and move on."
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