5 ways to be a tax-smart investor

Exchange-traded funds

ETFs look like mutual funds but trade like stocks. They're bundles of securities -- either stocks or bonds -- that track various indexes. The most popular ETFs use broad market benchmarks such as the S&P 500 (SPDRs or Spiders), the Dow Jones Industrial Average (Diamonds), or the Nasdaq 100 (QQQQs or Qubes). But there are ETFs that represent other slices of the market (midsized value companies; small growth companies; foreign companies) as well as various sectors (telecom, utilities, technology). And more are in the works.

Unlike mutual funds, ETFs can be bought and sold throughout the day, rather than just at the end of trading. But since they're passively managed, they tend to have extremely low expenses -- even lower than the cheapest index mutual funds. (Spiders, for example, have a 0.11% annual expense ratio, compared to the still-slim 0.18% charged by the Vanguard 500 Index (VFINX) mutual fund.) Like index funds, they tend to have little turnover, few capital gains distributions and a low dividend yield -- making them pretty tax efficient.

The problem for individual investors is that ETFs aren't no-load: you have to pay commissions to buy and sell them. If you're dollar-cost averaging -- investing regular sums over time -- those costs can easily swamp any break you get on annual expenses. ETFs are a better bet for those with a lump sum to invest.

Small investors can lose money if they trade actively, as well. Although ETFs are known for their ease of trading, the break you get on annual costs could easily go out the door if you're constantly buying and selling. The difference between a Spider and the no-load Vanguard 500 Index is only $7 a year on a $10,000 investment, after all; commissions can cost you $30 a pop or more.

Tax-efficient mutual funds

These funds are actively managed, but by pros who pay attention to the tax ramifications of their trading. Some simply keep turnover low, minimizing the capital gains they have to realize. Others try to match the sale of any winners with the dumping of their losers, so that gains can be offset by losses.

Some of these funds advertise their tax strategies in their names, such as Vanguard's Tax-Managed Balanced (VTMFX) fund, which invests in both stocks and bonds. Others simply deliver with their results. Oakmark (OAKMX) and Third Avenue Value (TAVFX) are two of the better-known funds that deliver a low tax impact to their investors.

Annuities

This option is last because, in my opinion, you should exhaust all the other possibilities first. (See "The worst retirement investment you can make.")

Deferred annuities sound good: There are no limits on how much you can contribute, the earnings grow tax-deferred and there's a built-in insurance policy that ensures your heirs get at least the amount you originally invested -- which can come in handy in the event you die while the market is down.

But these investments usually come with higher annual expenses than comparable mutual funds, along with significant surrender charges. Withdrawals are taxed as income, which means all those nice capital gains you built up over the years don't get the capital gains tax break. There's also a tax penalty if you tap the money before age 59½.

Then there are the estate-tax disadvantages. When you die owning stocks or mutual funds, the investments get a new value for tax purposes, which typically eliminates or drastically reduces any tax bill your heirs might owe when they sell. By contrast, your heirs will pay income taxes on withdrawals from any annuities they inherit.

In recent years, many insurers have added various guarantees to their annuity contracts -- so called "living benefits," in addition to the death benefit described above. These guarantees can ensure that you get back at least your original investment when you withdraw the money during retirement. But the cost for these guarantees tends to be high -- 0.4% on average, in addition to the average 2% annual costs for annuities -- and the likelihood you'll ever need the benefit is slim.

Given all that, the list of investors who could appropriately choose annuities is small indeed. Usually, they're high-income folks who have exhausted all other tax-advantaged possibilities for retirement saving and who just can't leave their investments alone. In other words, they need an annuity's tax-deferral feature to compensate for their active trading.

Liz Pulliam Weston's new book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.

Updated Jan. 4, 2008

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