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Morningstar.com's Interactive Classroom

Course 206
The Best Investments for Taxable Accounts

Introduction

You've invested all that you can in your employer-sponsored retirement plan. You've maxed out your IRA options, too. Yet you need to invest more to reach your goals. You need to set up a taxable account.

What types of investments should you keep in your taxable account if you want to minimize taxes? Here are six tax-friendly investment options, as well as strategies you can practice to minimize the tax bite.

Very Low Turnover Stock Funds

Financial pros argue that low-turnover funds (or funds that don't trade very often) are generally more tax efficient than high-turnover funds. That's somewhat of a myth. Morningstar has found that there's no one-to-one relationship between a fund's turnover rate and its tax efficiency. In fact, a fund with a 200% turnover rate can be just as tax efficient as a fund with a 50% turnover rate.

However, we have found that funds with exceptionally low turnover rates--below 20%--do tend to be tax efficient. Large-company index funds are tax friendly, for example, because they usually carry single-digit turnover ratios.

We've created a list of low-turnover U.S. stock funds using Morningstar.com's Fund Screener. To create the list, enter the following:

  • Under "Select Group," choose Domestic Stock.
  • Under "Turnover less than or equal to," choose 25%.
  • Click "Show Results" for the list.
  • On Results Page, choose "Portfolio"in the View drop-down box.
  • Click on "Turnover %" to rank funds on the list from lowest turnover to highest turnover.

You can manipulate any of the inputs, if you'd like, narrowing your search to funds in a particular Morningstar Category, or funds that earn a particular star rating, etc.

Tax-Managed Mutual Funds

Tax-managed funds are dedicated to limiting shareholders' tax burdens. They use a variety of strategies--not just one--to minimize taxes. For starters, they avoid dividend-paying stocks. They also strive to limit capital gains by holding their securities for a long time or by selling losing stocks to reduce their taxable gains.

Tax-conscious investors have a slew of these funds from which to choose. They can be hybrid funds that own both stocks and bonds, large-company funds, small-company funds, and foreign funds. In short, you could assemble a tax-friendly portfolio that invests in a variety of securities.

There are many fund-screening tools on the Web that can help. Here we useMorningstar.com's Premium Fund Screener to get a list of tax-friendly funds. (This toolis available to Morningstar.com Premium Members only, but nonmembers cansign up for a free trial.)

Once on Morningstar.com's Premium Fund Screener, follow these steps toset a screen to help you uncover inexpensive, tax-friendly funds with experienced managers:

  • Under the "Select Data to Screen on" drop-down menu, choose "AfterTax ReturnWithout Sale" under the Performance heading. In the pop-up window, select "5 Yr AfterTax Return(no sale) >= Category average." Hit OK.
  • Go back to "Select Data to Screen on" and choose "Tax Cost Ratio" under the Performance heading. Choose "5 Yr Tax Cost Ratio < Category average." Hit OK.
  • Go again to "Select Data to Screen on" and select "Management" under the Management and Purchase Data heading. Using the Data drop-down menuin the pop-up window, select "Fund Manager Tenure > Category average." Hit OK.
  • Return to the "Select Data to Screen on"menu, and choose "Fees & Expenses" under the Management and Purchase Data heading.Select "Expense Ratio < Category average." Hit OK.
  • Under "Select Data to Screen on," look under the Management and Purchase Data heading for"Closed to New Investment" andselect"Closed to New Investment = No" in the pop-up window. Hit OK.
  • Finally, go one last time to "Select Data to Screen on" and select "Distinct Portfolio Only" under the General heading. In the pop-up window, set this condition equal to "Yes." (This will filter out multiple share classes of the same fund in your results.) Hit OK.
  • Now hit "Click button to show results" and to view the funds that passed your screen.

Municipal Bonds or Municipal-Bond Funds

States, cities, municipalities, and county governments can all issue municipal bonds, or munis, to raise money. They use the proceeds to improve roads, refurbish schools, or even build sports complexes. The bonds are usually rated by a major rating agency, such as Standard & Poor's or Moody's, based on the quality of the issuer.

Why do tax-sensitive investors like munis? Unlike income from bonds issued by corporations or the federal government, income generated by municipal bonds is exempt from federal, and sometimes state, income taxes.

To choose between a taxable and a municipal-bond investment, you need to know your tax bracket. A muni bond may seem to yield a lot less than a taxable bond, but it could be a different matter after you take your tax rate into account.

Say you're an investor in a higher tax bracket who's choosing between a corporate-bond fund yielding 7% or a muni-bond fund yielding 6%. The corporate-bond fund may seem like the better deal, because its yield is higher. After taxes, though, the muni fund could actually be the higher-yielding investment.

To learn more about choosing muni funds, see Funds 309: Choosing a Municipal-Bond Fund.

Individual Stocks

One of the best ways to minimize taxes on your investments is to buy stocks. Unlike the typical fund investor, you could pay nothing in taxes. You can't beat that.

Well, you will still pay capital-gains taxes when you sell a stock, but if you hold your stocks for at least a year, you'll pay just the 15% long-term capital-gains rate (if you are in the 25% or higher tax bracket). And by choosing when you sell, you control when you pay the taxes.

To be a tax-free stock investor, avoid the two things that force funds to make taxable distributions to their shareholders: dividend-paying stocks and selling. Shun dividend-paying stocks because the dividends you get are taxed at 15%. And if you don't sell, you won't pay capital-gains taxes.

Exchange-Traded Funds

Exchange-traded funds (ETFs) are generally index funds that trade like stocks. For example, SPDRsSPY track the S&P 500 Index. Investors buy those shares on the American Stock Exchange.

Unlike mutual funds, which always pass capital-gains taxes to their shareholders, ETFs only generate taxes by owning dividend-paying stocks or by changing their holdings to reflect changes in their indexes. To minimize your tax bill, use ETFs that track large-company indexes, which change infrequently. Other indexes, such as those tracking small and midsize companies, change more frequently, and that means tax bills for shareholders.

We cover ETFs in greater length in Portfolio 403: Exchange-Traded Funds.You can also drop by Morningstar.com's ETFs Centerto learn more about these types of investments.

Variable Annuities

Variable annuities (VAs) are essentially mutual funds wrapped in an insurance package. When you buy a variable annuity you can direct your investments into a range of stock or bond portfolios, called subaccounts, made available within a particular policy. Tax-weary investors are drawn to variable annuities because contributions grow tax-deferred until retirement, when gains are taxed as income upon withdrawal.

Mutual funds are usually a better deal than VAs, though. Because of the insurance layer, VAs come with relatively high price tags.

Of course, not all VAs are overpriced. The low-cost VA leaders include companies that are familiar tothrifty mutual fund shoppers--including Vanguard andT. Rowe Price. In fact, their VAs come cheaper than many mutual funds, insurance wrapper and all.

VAs may offer current tax deferral, but the IRS does demand a trade-off: VAs are an estate-tax liability. When you die, your heirs will owe income taxes on your account's appreciation. If you passed along fund or stock investments instead, those securities would be stepped up for tax purposes, meaning your heirs' cost basis would be the value of the investments as of your death; they would only owe taxes on subsequent appreciation. We discuss VAs again in Portfolio 401: Variable Annuities.

Other Ideas for Tax Relief

Here are some other strategies you can practice to limit how much of your taxable account Uncle Sam gets to take.

Buy and hold.
The best way to avoid capital-gains taxes is simply to refuse to sell an investment. Of course, you (or your heirs) will eventually need to sell shares to cash in on an investment's appreciated value. Still, it makes more tax sense--and more investing sense in general--to buy and hold for the long run. If you really want to trade on a regular basis, do it in an individual retirement account or a 401(k) plan, since those transactions are shielded from taxes.

Pay attention to holding periods.
When you sell any investment, you have to pay capital-gains tax on your profits. Under current law, you owe taxes on short-term gains--those from investments that you've held for a year or less--at your ordinary income-tax rate. By contrast, if you've owned the investment for more than a year, you'll owe much less. In 2012, that long-term rate is 15% if you're in the 25% tax bracket or higher, and 5% if you're in the 10% or 15% tax bracket.

Thus, if you have a choice between selling a winning investment that you've held for six months and one that you've held for two years, unloading the latter will result in a lower tax hit. Or, if you're considering selling an investment that you bought 11 months ago, waiting a few extra weeks could be worth your while from a tax standpoint.

Offset capital gains with losses.
If you sell an investment for less than you paid for it, the difference counts as a capital loss. The silver lining to such losses is that they cancel out capital gains, lowering your taxes overall. If your capital losses exceed your capital gains in a given year, you don't have to pay any capital-gains tax, and you can deduct a net loss of up to $3,000 from your taxable income (and carry over any unused losses into the next year).

That's why it's sometimes a good idea to think about selling some of the losers in your portfolio near the end of the year. If you still like these investments for the long term, you can buy them back after waiting 30 days. This rule prevents "wash sales," in which somebody sells a stock to claim a capital loss but then repurchases it immediately to retain ownership.

Pay attention to cost basis when selling shares.
When you sell an investment, the taxable capital gain depends on your cost basis, or the price you paid for the stock. If you bought shares of the stock at different prices, you can sometimes reduce your capital gains, and thus the tax you pay, by specifying that you're selling shares bought at the higher price.

For example, suppose you buy 100 shares of a stock at $10 a share. The stock rises to $20, and you buy another 100 shares. Eventually the stock reaches $30, and you decide to sell 100 of your shares.

Without specific instructions, most brokers and fund families would sell the first shares you bought, and your capital gain would be $2,000, or the $3,000 sale price minus your $1,000 cost basis. But if you specify that you want to sell the shares you bought for $20, your capital gain will only be $1,000, or $3,000 minus a $2,000 cost basis.

There's one catch: You usually need to specify in writing which shares you're selling. That can be difficult, especially with discount brokers. Still, it's worth the effort if you've bought shares at very different prices and need to sell some of them.

Quiz 206
There is only one correct answer to each question.

1 Which statement is true?
a. Funds with exceptionally low turnover rates tend to be tax efficient.
b. Funds with exceptionally high turnover rates tend to be tax efficient.
c. There's a one-to-one relationship between a fund's turnover rate and its tax efficiency.
2 How do tax-managed funds limit shareholders' tax burdens?
a. They avoid dividend-paying stocks.
b. They limit capital gains by holding securities for a long time.
c. They avoid dividend-paying stocks, they hold securities for a long time, and they sell losing stocks to offset gains in winning stocks.
3 You're a tax-sensitive investor. Which is the better bond for you?
a. A municipal bond yielding 5%
b. A corporate bond yielding 6%
c. It depends on your tax bracket.
4 What are exchange-traded funds?
a. Mutual funds wrapped in an insurance package.
b. Index funds that trade on an exchange.
c. Mutual funds that buy stocks that trade on an exchange.
5 Which is a benefit of capital losses?
a. They can cancel out capital gains, and to the extent that losses exceed gains, you can deduct a net loss of up to $3,000 from your taxable income.
b. They cancel out capital gains.
c. You can deduct a net loss of up to $3,000 from your taxable income.
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the quiz page.
Copyright 2006 Morningstar, Inc. All rights reserved.
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