If you’re like most investors, you’re paying far more in taxes each year than you need to. So let’s take a look at how you can keep the tax bite on your portfolio to an absolute minimum by legally stiff-arming the IRS.

Top-performing mutual funds love to tout their annual returns. But while these returns take operating costs (expenses) into account, they do not consider taxes. And two funds with identical net returns can deliver drastically different returns after taxes.

[ad#Google Adsense 336×280-IA]Here’s what I mean…

Mutual funds are required by law to distribute at least 90% of their realized gains each year.

That means you can get hit with a big tax bill even if you haven’t sold a share.

Inside each fund, managers are often buying and selling like mad, trying to beat their benchmarks.

While this might not hurt the manager’s annual bonus, it can have a devastating effect on your real-world returns.

After all, you owe taxes on all those realized short- and long-term capital gains, even if you haven’t sold a single share.

Lipper, a global leader in fund information and analytical tools, recently published a study on “Taxes in the Mutual Fund Industry.”

It found that investors surrender over $24 billion to Uncle Sam in one year, just for buying and holding mutual funds! Taxes gobbled up 15% of the gross return of the average U.S. diversified equity fund. And the tax hit was even worse for the average U.S. taxable bond fund. Here 38% of the gross return was lost to taxes, nearly double the cost of operating expenses and loads combined.

If you are voluntarily surrendering thousands of dollars to the IRS each year, you are not going to reach your financial goals. (Or, at least, not very soon.) You need to tax-manage your portfolio to increase your real-world returns.

The first order of business is to place the appropriate assets in the right accounts for maximum after-tax returns. In short, you need to put the most tax-inefficient securities into your tax-deferred accounts and the remaining ones in your taxable accounts.

For example, real estate investment trusts are highly tax-inefficient. Most of your return will come in the form of dividends, and these are taxable at your income tax rate, not the lower capital gains tax rate. So you want to hold REITs in your retirement account.

Other tax-inefficient assets include corporate and U.S. government bonds. Here the majority of the return comes from interest income – and all of it is taxable. Income funds will typically make capital gains distributions from time to time, as well. So these also belong in a tax-deferred account.

Treasury inflation-protected securities give you a double whammy. The semi-annual interest payments on TIPS are taxable, the same as other Treasury securities. However, investors are also taxed on the annual inflation adjustments to the principal. This is commonly described as taxing “phantom income.” So you should also hold your inflation-adjusted Treasurys in a tax-deferred account.

Municipal bonds, of course, are tax-exempt and are best held in your nonretirement accounts.

Equity index funds – which are highly tax-efficient – and individual stocks that you intend to hold long term should be held in your nonretirement accounts. Here you can control your capital gains tax liability and even offset your realized gains with realized losses, where possible.

Tax management is essentially an asset “location” strategy. You want to locate your least tax-efficient assets inside your retirement account and your most tax-efficient outside them.

Please don’t think this isn’t worth the trouble. The average mutual fund takes 2.5% in annual costs each year. Taxes take another 2%.

No wonder the average mutual fund investor feels like he’s on a slow boat to China. Even if you’re earning only the market’s long-term average return of 10% a year, expenses and taxes are gobbling up 45% of your annual return.

As Vanguard founder John Bogle once said, “Fads come and go and styles of investing come and go. The only things that go on forever are costs and taxes.”

In short, taxes matter… a lot. Follow this basic asset location strategy and you’re assured of higher real-world, after-tax returns.

I’ll have more great ideas on how to cut your annual tax bill in my next few columns. So stay tuned…

Good investing,

Alex

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Source: Investment U