Do you know how much taxes are eroding your investment returns? It could be more than you think. Studies by the Vanguard Group suggest that taxes can erode the net returns of domestic stock funds by as much as two percent annually. That might not sound like much, but this small percentage can represent a huge hit. Let's take a look at what would happen over 25 years to a $250,000 portfolio, earning 6% a year, that gets dinged with an annual 2% tax hit. Without the tax burden, the portfolio would grow to $1.1 million. With the two-percent hair cut, the nest egg would end up with $678,00. That’s a difference of $428,000! Luckily, there are ways to limit tax damage to your portfolio. Here are six ideas:

1. Direct more money into retirement accounts.

The beauty of retirement accounts, such as 401(k)s, 403(b)s and IRAs is their ability to ward off taxes. As long as the assets remain inside a retirement fund, you won’t be liable for taxes. What’s more, you will pocket a tax deduction for contributing to workplace plans and traditional IRA’s.

2. Pay attention to location.

Ideally, you’ll want to put the type of investments that tend to be tax hogs in retirement accounts where they won’t spin off taxable income and capital gains. In contrast, investments that are inherently tax efficient are better off sitting in taxable accounts which don't enjoy the tax protections of retirement accounts.

Tax-inefficient investments

Investment that are typically better off in retirement accounts include:

  • Real Estate Investment Trusts (REIT’s)
  • Taxable bonds
  • High-turnover stock funds

Tax-efficient investments

These investments are generally better off in taxable accounts:

  • Tax-free municipal bonds
  • Tax-managed mutual funds
  • Equity index funds and exchange-traded funds
  • Individual stocks

3. Understand the difference between tax efficient and inefficient mutual funds.

A tax-efficient mutual fund strives to limit capital gains distributions that are as welcome as termites and can seem just as hard to eradicate. When a mutual fund distributes capital gains, investors must pay taxes on this money, even though they haven't cashed in their shares. And these "gains" are strictly ephemeral. Sure, you technically get to pocket gains, but the value of your holdings are reduced by the same amount so it's a wash, except you pay taxes on this wash.

4. Check the tax-adjusted returns.

You can get an idea about whether a mutual fund is tax efficient by looking at the pretax and tax-adjusted returns of individual funds. You can obtain those figures for many mutual funds on the website of Morningstar, a popular investment research firm. To show you what you can find, I pulled the performance figures for Vanguard 500, which is one of the nation’s largest mutual funds. This index fund, which invests in large U.S. corporations, is a tax-efficient fund. When you look at the 15-year pretax and tax-adjusted returns, there is only a .41 percentage point difference.

In contrast, take a look at Vanguard REIT Index Fund. REITs are tax inefficient because they tend to generate lots of dividends, which are taxed the same as the investor's income rather than at more favorable capital gains rates. You can see from the figures below that the difference between the pretax return and the tax-adjusted return over 15 years was 1.67 percentage points larger.

5. Harvest Tax Losses

Another way to reduce your tax liability is to look for opportunities to sell investments at a loss to offset capital gains from your winners. For instance, if you sold a stock for a $5,000 loss, you could use that loss to offset a $5,000 profit when selling a winning stock. By doing this you would owe no capital gains tax on the stock that appreciated. If you don't have any capital gains to offset, you could take up to $3,000 of your loss to reduce your regular income. Any unused loss can be carried forward to the next year and beyond if necessary.

6. Understand if any of this matters.

Keep in mind that pursuing tax efficiency is going to be irrelevant if you've got all your money tied up in tax-protected retirement accounts.

Learn More...

9 Year-End Tips to Save on Taxes Stretching an Individual Retirement Account The Right Way to Invest in  401(k)

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