Opening your brokerage statement these days is like jumping into an icy lake: Your heart races, your eyes widen and you wonder why you ever took the plunge. But despite the turmoil in the financial markets, there's one foolproof way to protect some of the hard-fought gains in your taxable accounts: Go tax-efficient. Many investors see 40% of their annual returns chewed up by taxes, experts say. "In principal, tax-efficient investing is structuring your portfolio to minimize taxes," says Louis Kokernak, a financial planner with Haven Financial Advisors in Austin, Texas. Fortunately, offerings from big-name mutual fund companies such as Vanguard and Fidelity make it easy to lower the tax exposure in your taxable portfolio. And while these tax-efficient funds may not help you avoid a drubbing when the S&P 500 plunges, they will keep you from seeing even more of your returns disappear into Uncle Sam's pocket. How do they work? Strategies vary from fund to fund, but the primary objective of portfolio managers like Michael Buek, who runs Vanguard Tax-Managed Capital Appreciation ( VMCAX), is to avoid triggering capital gains that get passed on to shareholders. One common way managers keep capital gains low is to reduce portfolio turnover, or how often holdings are bought and sold. Since capital gains only come with the sale of a winning stock, low turnover goes a long way in lowering your tax exposure. Buek, for example, buys and sells an average of just 5% of his fund's holdings every year. Many funds' annual turnover is well over 100%.
According to fund-tracking firm Morningstar, Buek guides his fund to closely follow the Russell 1000 Index of large- and mid-cap stocks. He tweaks the fund's holdings, however, to avoid the index's highest-yielding stocks, which would trigger capital gains through their dividend payouts. Buek also sidesteps tax exposure for his shareholders by offsetting winning positions with the sale of losers -- another common strategy among managers of tax-efficient funds. The results? Morningstar analyst Dan Culloton recently noted that the fund's 10-year pre-tax returns are better than 75% of its peers in the large-cap blend category. After taxes are figured in, the fund beats 85% of its competitors. When to use 'em, where to find 'em Tax-efficient funds can be a great way to protect your returns, but not every investor needs to worry about tax efficiency. That's because capital gains on tax-advantaged accounts such as 401(k)s and IRAs aren't calculated on a year-to-year basis like ordinary taxable accounts. As a result, stick to using tax-efficient funds in your taxable accounts. To begin looking for tax-efficient funds, check sources like Morningstar or the Mutual Funds Center at Yahoo! Finance. Both sites let you screen for strong-performing funds with low turnover rates and low tax exposure. Also, many funds advertise their tax-efficient bent right in their names, like Fidelity Tax-Managed Stock ( FTXMX). Portfolio manager Keith Quinton has guided the fund to a five-year annualized return of 7.2%, outperforming the benchmark S&P 500 as well as nearly 90% of its large-blend category rivals. Many actively managed funds result in high turnover, which often makes them bad choices from a tax standpoint -- no matter how stellar their returns. As a result, Kokernak says investors also should consider funds that track indexes such as the S&P 500. "Index investing tends to be a very tax-efficient way to do it," he says. Taking a few steps to protect your hard-earned gains can have a dramatic long-term impact on your financial health. Tax-efficient funds offer a great way to minimize capital gains -- and keep more money in your pocket.