One Way to Shrink Your Taxes: Buy Mutual Funds, ETFs

By Nathan Sonnenberg
NEW YORK (AdviceIQ) — After tax season, when they realize exactly how much they paid at home, a number of my friends, colleagues and clients asked me what they should do to reduce their burden next year. While I'm not a tax professional, I certainly pay attention to tax rules and rates regarding investing.

My short answer to their question was: Create a portfolio of low-fee, thoughtfully constructed stock index mutual funds or exchange-traded funds. Yet not all of them do the job for you. Here's how to find the right one.

An index mutual fund is a passively managed fund that tracks the performance of a certain index, such as the Dow Jones Industrial Average, or a broad bond or commodity index. An ETF is similar to an index mutual fund, but is traded on the stock exchanges, like a stock. Rather than buying all of the stocks in the Dow Jones or Standard & Poor's 500, you can simply own an ETF that tracks that index.

Because index mutual funds or ETFs are not actively managed, their fees are often low. Also, their low turnover — how frequently stocks are bought and sold within a portfolio — provides tax benefits as excess activity creates the potential for more taxable events.

Read More: Relying on the Stock Market? Nothing Goes Up Forever

Consider these three aspects before buying an index fund or ETF:

1. Market exposure. Decide what you want to own. This is obvious, but not simple. Choosing from the broad number of stock index providers can be overwhelming (the Dow, S&P 500, Russell 2000, MSCI, FTSE). Therefore, it's important to understand what markets, countries, regions, industries, sectors and stocks the index fund you buy contains. Is your goal to own large stocks, small stocks or both? Do you want U.S. stocks, international, emerging-market or all of the above?

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