How to Keep Mutual Fund Taxes Low

By , Staff writer of The Christian Science Monitor

Ok so holding the lid on taxes pays off in a big way. But how do you manage taxes when someone else - a mutual fund manager - is calling the shots with your money?

You still have a lot of control, financial planners say. Here are some strategies:

1. Gimme Shelter. Contribute to your employer's 401(k) or 403 (b) retirement plan up to the maximum level before saving in a taxable account. Contributions to these plans reduce your taxable income. And earnings are not taxed until withdrawn.

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An individual retirement account serves the same purpose.

2. Minimize ordinary income. If you don't need current income, consider avoiding it in favor of long-term growth. Dividends or bond interest in a mutual fund is taxed at your regular tax rate, as high as 39.6 percent. Aggressive growth funds typically generate much of their income from capital gains, as opposed to regular income, thus reducing your tax bite.

3. Invest in tax-exempt funds. Municipal bond income, for example, is exempt from federal taxes (and state taxes if the fund focuses in your home state).

4. Index. Index funds, which buy and hold the stocks in a market index like the Standard & Poor's 500, have almost no turnover, and thus a tiny tax bite.

But if index investors bailed out all at once, remaining investors could be left with a big taxable distribution on years of capital gains that others investors reaped earlier in the year.

One twist: Some index funds aim for tax efficiency. If investors are redeeming shares in the fund, the manager can sell losers to offset gainers, rather than selling pieces of the whole index. Vanguard Group has several index funds of this sort.

5. Don't overdo it. Remember, the bottom line is your after-tax total return, not just low taxes.

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