Tax-Smart Investing

Tax planning is an important but often overlooked aspect of a long-term investing strategy. After all, your primary concern should be what you keep after taxes, not necessarily a fund's reported return. But from a tax standpoint, investing in funds is tricky because they are required to pay out to shareholders essentially all of the gains they realize each year, as well as dividends and interest payments that they have gathered.

None of this matters if you're investing in an IRA or other tax-deferred vehicle. But if you invest in a regular account, you can get stuck with a tax bill -- talk about adding insult to injury -- even if the fund gets creamed.

Tax-efficiency, a relatively controllable part of investing, will become even more important once the markets turn up, which they inevitably will do. Assessing the tax consequences of bond funds, nearly all of which are divided between tax-free municipal bonds and taxable bonds, is pretty clear-cut. Muni bonds most likely belong in your taxable account, and taxable bonds go in the tax-deferred camp. But the optimum account for stock funds is much less clear.

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Generally, you're better off placing high-turnover stock funds that generate large capital gains (especially short-term gains, which are subject to high rates of taxation) in a tax-deferred account. For instance, Ken Heebner typically turns over the portfolio of CGM Focus about four times a year, constantly generating taxable gains: Over the past five years through February 28, CGM investors lost an average of 2.5 points a year (nearly all of their return) to the tax man.

Funds with a consistent buy-and-hold philosophy and low turnover are generally better for your taxable accounts. Four in this camp are Selected American Shares (symbol SLASX), Long-leaf Partners (LLPFX), Vanguard Primecap Core (VPCCX) and T. Rowe Price Small Cap Value (PRSVX).