5 ways to be a tax-smart investor

By Liz Pulliam Weston

Many investors will never need to learn a thing about tax-efficient investing.

That's because all their investing will be done through tax-advantaged plans: 401(k)s or 403(b)s, IRAs and Roths, 529 college savings plans and Coverdells.

Lots of other investors, though, have wider horizons. The tax law now makes taxable -- but tax-smart -- investing more attractive. And there are some situations where taxable accounts can make more sense than their tax-advantaged cousins. These situations include:

• When you want easy access to your money. Tax-deferred accounts tend to come with lots of rules, regulations and penalties for early withdrawal.

• When you're short on time. People who start investing very late for a goal -- whether it's college or retirement -- may not have enough time to reap significant benefits from a tax-advantaged plan.

• When your workplace retirement plan is terrible. For most savers, funding a 401(k) or 403(b) still makes sense. But if you don't get a match on your 401(k), if the investment choices reek and if you expect to be in a higher tax bracket in retirement, then investing on your own can make sense.

• When you've exhausted all your tax-deferred options and want to invest more. You may not have a workplace retirement plan, or you may be able to save more than your available tax-advantaged possibilities allow.

Here are some of your options:

Individual stocks

The classic tax-efficient portfolio is a selection of growth stocks bought and held for the long haul. Growth stocks were preferred because they tended not to pay dividends, which were taxed at high income tax rates.

President Bush's 2003 tax cut made it much easier to construct a more diversified portfolio with a low tax impact. The cut drove the top federal capital-gains rate down to 15% and made the same rate apply to dividends issued by domestic stocks and mutual funds.

But if your taxable income puts you in the 10% or 15% bracket (that's $65,100 for married filing jointly in 2008, half that for singles), your capital gains and dividends rates is zero, at least from 2008 to 2010. (In 2007, you owe only 5%.)

That means you can add value stocks to your growth selections without major suffering at tax time. You can rebalance occasionally and, as long as you've held the stocks at least a year, benefit from a lower capital gains rate. Personal finance software such as Money or Quicken can help you identify the best combination of securities to sell to minimize taxes.

If you want to round out your portfolio, you can invest in municipal bonds, which pay tax-free interest, and tax-free money market accounts. (Corporate bonds, particularly the high-yield variety, are better off in tax-advantaged accounts, because their interest is taxed at income tax rates.)

Another investment to consider: preferred stocks, which typically pay rather generous dividends on a set schedule. These issues aren't like traditional stocks, in that they represent a debt contract rather than a piece of ownership in the company. So you don't get to benefit from any rise in the company's value, but you do get a bond-like income stream.

But owning preferred stocks, or individual stocks of any kind, isn't for everybody. Individual issues are riskier than diversified mutual funds, and they require a lot more research and monitoring. You need to pay attention to the news and other events that affect your stocks, and have a sell strategy for each. (The days of buy and hold forever are pretty much gone for good in this fast-changing global economy.) It's also tough to get properly diversified. Some financial planners believe you need a portfolio of $250,000 or more to achieve true diversification.

You should know, too, that payouts from foreign stocks and real estate investment trusts don't qualify for the dividend tax break. For maximum tax efficiency, these investments should be held in tax-advantaged retirement accounts.

Index funds

Index funds, which mimic a market benchmark such as the Standard & Poor's 500 ($INX), have long been the easiest way to construct a tax-smart portfolio. These funds don't do much buying and selling, which is what tends to trigger big tax bills for shareholders. (The makeup of index funds usually changes only when the underlying benchmark changes.) They tend to have low expense ratios, meaning more of your gains stay in your pocket rather than going to pay the fund companies' expenses.

The biggest drawback is, of course, that you'll never beat the market with a market-matching index fund. There are plenty of folks out there (brokers, many of them) who argue that you'll be better off in actively managed funds. And it's true that if an actively managed fund posts spectacular, market-beating returns, you probably wouldn't care much about the tax bite, since you'd still be way ahead of an index fund.

The problem is that it's tough to figure out in advance which funds are going to turn in breakout performance. More than half of actively managed domestic large-cap funds fail to best the S&P 500 index, reports Morningstar, the mutual funds research company.

Many advisers would argue it's impossible to pick those winners consistently, so you're better off sticking with market-matching index funds. If you still want to gamble with an actively managed fund, make sure it's tucked into a tax-deferred account. Otherwise, you'll wind up paying income taxes on the short-term capital gains generated by the constant churn in these kinds of funds.

Continued: Exchange-traded funds

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