Tax Efficient Investing

Buy and hold: Yes, long-term investing is boring. Trading actively is speculation though, not investing. Take a long-term approach and use a buy and hold strategy in your overall portfolio.

Turnover: Turnover can occur at the portfolio level and at the mutual fund level. The rule of thumb is that higher turnover equals lower returns. Studies indicate that a mutual fund turnover percentage of 100% reduces portfolio return by more than 1%. According to Morningstar, the average stock fund has a turnover ratio of 111%!

The reason higher turnover equates to lower returns is partly transaction costs and partly taxes. Higher turnover means that there is more short-term buying and selling. Short-term gains are taxed at ordinary income levels, which are higher than taxes on long-term gains.

Make sure your mutual funds have a low turnover ratio (below 20% is recommended, but it depends on the asset class). Not only should you be using a buy and hold long-term approach at the portfolio level, but also at the asset class level.

Enter your federal marginal tax rate and hit calculate to compare the difference in tax rates on short-term gains and long-term gains.

Federal Marginal Rate: Short-term Gains: Long-term Gains:
 

Tax-efficient investments : Besides low turnover, taxable investments should be structured for tax-efficiency. Some mutual funds are "tax-managed", meaning they intentionally try to curtail taxable distributions by minimizing dividends and internally offsetting gains and losses. Tax-free municipal bonds are another option to consider.

Appropriate placement : Asset placement is a simple concept. By placing assets in different accounts, you try to minimize current and future taxable distributions. Some strategies include:

Sometimes this is easier said than done. The trick is to implement these strategies without disrupting the overall asset allocation.

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