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How to Cut Taxes on Your Nest Egg: Tax Shelters

Many actively managed equity funds belong in shelters. Portfolio managers often sell winning stocks and book capital gains. In their prospectuses, some funds indicate that they do not aim to limit tax bills. Portfolio managers take this position because many shareholders hold the funds in tax-shelters.

Equity funds can generate particularly large bills if they hold dividend stocks, which produce income that can be taxed at rates of up to 15%. "If an equity fund has a robust dividend yield, then it could be better to put it in a tax-sheltered account," says Christine Benz, Morningstar's director of personal finance.

A fund that should be sheltered is Yacktman (YACKX), which has a tax-cost ratio of 1.18. Yacktman ranks as one of the top performers of the past decade, but the big gains resulted in steep capital-gains tax bills. In addition, the fund holds many dividend-paying stocks.

Most taxable bonds belong in shelters. Interest income from bonds can be taxed as ordinary income. Among the least tax-efficient choices are high-yield bonds, which pay rich yields. Most high-yield bond funds have tax-cost ratios of more than 2.5. Top-performing choices with steep tax-cost ratios include Transamerica Partners High Yield Bond (DVHYX) and Metropolitan West High Yield Bond (MWHYX).

Treasury Inflation-Protected Securities, TIPS, have special reasons to be sheltered. TIPS provide returns in two ways. Like other bonds, they make fixed interest payments. In addition, the principal value of the securities rises along with the consumer price index. Say you put $1,000 into TIPS, and inflation rises by 3% for the year. Your principal will rise to $1,030, and you will owe taxes on the appreciation. A fund with strong returns and a steep tax-cost ratio is Hartford Inflation Plus (HIPAX). By putting TIPS in your retirement account, you can protect you nest egg against inflation, while sheltering the assets from the taxman.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.
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