Blogs > Your Money

Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Saturday, May 1, 2010

Ways to Reduce Taxes on Your Portfolio Income

In our recent blog titled “Get Ready for More Taxes”, we discussed the fact that higher taxes are most assuredly in our future. And, with the high level of government spending we are currently seeing, it seems very likely that the future will also bring us higher inflation. It will become increasingly important therefore, to pay close attention to investment costs and taxes in order to avoid a decrease in our net income going forward.

For those who invest primarily in mutual funds, we’ve outlined below some things you can do to minimize the taxes generated by your portfolio:

(1) Pay attention to your mutual funds’ Morningstar® Tax Cost Ratio (TCR) and Potential Capital Gains Exposure (available online at The TCR represents an estimate of the percentage-point reduction in an annualized return that results from income taxes. The Potential Capital Gains Exposure (PCGE) is an estimate of the percent of a fund's assets that represent gains. It measures how much the fund's assets have appreciated, and is therefore an indicator of possible future capital gain distributions. The lower the TCR and PCGE are, the better, when it comes to taxes.
(2) Morningstar also ranks funds on tax efficiency in their respective category. Called the % Rank in Category, it is a fund's tax-adjusted total-return percentile rank for the specified time period relative to all funds that have the same Morningstar category. A rank of “1” is best, “100” the worst. A low rank is more meaningful, the more funds there are in a category. While a fund may be best in its category with respect to tax efficiency, it doesn’t necessarily mean it is tax efficient. Nevertheless, if your asset allocation requires an investment in a specific category, it’s best to find a fund that rates well compared to its peers.
(3) Pay attention to your mutual funds’ turnover ratio. A turnover ratio of 50% indicates that half of the funds portfolio is replaced annually by other stocks. Turnover can result in higher taxes (though not necessarily) and certainly can lead to higher transaction costs.
(4) Consider using index funds in your portfolio. Since index funds trade less often than actively managed funds, index funds tend to have significantly lower expense ratios and often trigger lower taxable income.
(5) Consider using exchange traded funds (ETFs) in your portfolio. Since ETFs trade like a stock, you can minimize the capital gains generated by the ETFs, whereas mutual funds pass through capital gains annually to shareholders. A recent article in the Wall Street Journal, however, points out some problems with some types of ETFs. Readers may want to review the article titled “Hidden Tax Traps Inside ETFs” by Jason Zweig, April 17, 2010. The article suggests that investors be sure to review the tax considerations detailed in the ETF prospectus prior to investing.
(6) Place income-producing assets (i.e. bond funds, dividend paying stocks and funds, and REITs) in your retirement accounts and place non-income-producing assets in your taxable accounts (index funds, tax-efficient funds, growth stocks and growth mutual funds).

If you are a do-it-yourself investor who has the time and knowledge to pick your own stocks, you can eliminate the pass through of capital gain distributions that result annually from mutual funds. We believe, however, that for most investors the benefits of professional management and broader diversification of mutual funds (including index funds and ETFs) will serve them well.

Paying attention to fund expenses and taxes, while important now, will become even more important in the future to keep up with inflation and rising taxes.


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