How to Make Your Savings Tax-Efficient

Investors have two reasons for procrastinating on tax returns: doing them is such a big, miserable hassle, and the result can be a nasty tax bill.

The first problem is, well, a fact of life. But it’s possible to do something about the second, by improving “tax efficiency.” This is the time of year to think about that, as the recently arrived 1099 forms from your bank, brokers and mutual fund companies will help you uncover the inefficient aspects of your portfolio.

The 1099 forms show several types of taxable income: interest, dividends and capital gains, both long- and short-term.

To minimize the annual tax bills from these income sources, consider shifting to comparable holdings that don’t churn out as much annual income.

Many actively managed mutual funds pay large annual distributions from profits the fund earned by selling holdings during the year. Index-style funds, which use a buy-and-hold strategy, generally have smaller yearly distributions.

Also, there are a number of “tax-managed” funds designed to minimize annual taxes even if they are actively managed. Managers, for example, may take extra care to find money-losing investments to sell, offsetting gains on winners. Or they may postpone sales of winners until they can get the lower long-term capital gains rate for investments held longer than a year.

Why don’t all funds do that? Because many investors own funds in tax-favored accounts like IRAs and 401(k)s, where there are no annual taxes. Managers don’t want the trouble and expense of tax-reduction strategies if most of the fund’s investors don’t care about them, especially if those maneuvers can reduce returns.

That gets to the second tax-cutting strategy: putting the annual income producers into those tax-favored accounts. In addition to any funds that produce big distributions, this would include those that pay a lot of interest, such as bond funds. In taxable accounts, interest is taxed at income-tax rates as high as 35%. So, unless you need the interest income right away, put interest producers into an IRA or 401(k). That way you won’t pay tax until the money is withdrawn, though you’ll still pay at income-tax rates. Unless, of course, you use a Roth IRA, where withdrawals are tax-free.

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