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.

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.