Of course, taxable accounts play a part in many investors' portfolios. For these accounts, your focus should be on the most tax-efficient investments.
Today's investors have more tax-efficient funds to choose from than ever before. Some of these funds are billed as "tax-managed" and focus specifically on maximizing after-tax returns, often by limiting buying and selling of shares (many follow an index strategy) and by instituting policies to discourage investors from frequently moving in and out of the fund.
Here are some other strategies common to funds specifically identified as "tax-managed":
- HIFO (highest-in, first-out) accounting. When selling shares of a security, fund managers can keep the taxable gain passed through to shareholders as low as possible by first selling the highest-cost shares. This method is often more tax-efficient than simply selling the shares that have been owned the longest (and which may have been purchased at a lower cost than other shares).
- Loss harvesting. When managers sell securities that have lost value at the same time they sell securities that have increased in value, they can offset or reduce taxable gains.
- Redemption fees. Managers can charge redemption fees to discourage shareholders from redeeming their shares soon after investing. Redemptions can cause a fund's manager to have to sell the holdings, thus triggering capital gains for the remaining shareholders. Beware: Some funds charge "redemption fees" that have nothing to do with trying to minimize taxes. If a fund you're considering charges a redemption fee, make sure it's paid to the fund, where it typically defrays any costs associated with a redemption—not to the fund management company, where it doesn't benefit fund shareholders at all.
Even funds that don't claim to be tax-managed can still be relatively tax-efficient—especially if their managers use the strategies outlined above.