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How to Cut Taxes on Your Nest Egg: Tax Shelters

NEW YORK ( TheStreet) -- Congress could raise taxes next year, so this is a good time to prepare for the worst by making maximum use of the shelters offered by IRAs, 401(k)s and other retirement accounts. Earnings from sheltered assets can compound tax-free until you take withdrawals.

If much of your portfolio must remain in a taxable account, then you will have to decide which assets to shelter and which to leave out in the cold. Your aim should be to protect those investments that generate the biggest tax bills.

Among the most tax-efficient holdings are stocks that pay no dividends. If you own such shares in a taxable account and never trade, you can postpone paying taxes indefinitely. But if you tend to trade rapidly, then you could generate short-term capital gains, which are taxed as ordinary income at rates of up to 35%. To avoid big bills, heavy traders should keep stocks in a shelter.

Mutual fund investors face more complicated choices. Every time a fund sells a stock at a profit, shareholders can owe capital gains taxes. To avoid big bills, consider using index funds. Because they tend to buy and hold, the funds generate only limited capital gains bills. But keep in mind that not all index funds are the same. "Index funds can be relatively tax inefficient if they track a narrow slice of the market, such as small-cap value stocks," says Donald Bennyhoff, a senior investment analyst at Vanguard Group.

Small-cap index funds must sell a stock as soon as it grows to be a mid-cap. When that happens, the portfolio can generate capital gains tax bills that must be paid by shareholders. Funds that track the total stock market may be more tax efficient because they rarely need to sell stocks.

To decide whether to shelter an index fund or not, consult a measure known as the tax-cost ratio, which is calculated by Morningstar and other data providers. If taxes erode a fund's return by 1 percentage point, then the tax-cost ratio is 1.0. Among the most tax-efficient index funds is Vanguard Total Stock Market (VTSMX), which has a tax-cost ratio of 0.29. A candidate for a shelter is Vanguard Mid-Cap Value Index (VMVIX), which has a tax-cost ratio of 0.72.
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