Become a tax-savvy investor
You know the age-old adage: Taxes are a fact of life
For mutual fund investors, they can be particularly frustrating.
In fact, Vanguard studies have shown that taxes can reduce the net returns of the average domestic stock fund by as much as two percentage points annually.*
Of course, it's unrealistic to expect your investments to grow and completely avoid taxes. But there are things you can do to help make the bite less painful. By arming yourself with some basic information and keeping an eye on the impact of taxes as you build and monitor your portfolio, you may be able to diminish their erosive effect on your long-term returns.
Maximize your retirement contributions
By stashing away as much money as possible into tax-advantaged retirement accounts such as traditional IRAs and 401(k) plans, you'll get a break on any pre-tax contributions you make and enjoy tax-deferred earnings until you begin to withdraw the assets.
If your employer offers a plan, be sure to sign up and maximize your contributions allowable by law as soon as possible. Consider contributing at least enough to get the full employer match if that option is available. It's free money, so don't pass it up.
Consider the three L's: location, location, location
We all know that asset allocation—choosing the appropriate mix of stocks, bonds, and cash investments for your goals—is an important step in investing. A closely related process is asset location.
To further minimize the impact of taxes on your investments, consider placing the most tax-efficient holdings (such as tax-managed, index, and tax-exempt funds) in your taxable accounts while holding tax-inefficient investments in your tax-advantaged accounts—such as IRAs or employer plans.
Avoid membership in the "frequent trading club"
Try to limit sales of fund shares in your taxable accounts. This will allow you to reduce the capital gains you realize and defer taxes on a higher proportion of unrealized capital gains. More about selling mutual fund shares in a taxable account »
Rebalance to keep your asset mix on target
Changing financial markets can cause your actual asset mix to drift from your target allocation significantly over time. To reduce the risk of being overextended in a particular asset class and maintain the tax efficiency of your investments, periodic rebalancing is wise. One common guideline holds that you should review your portfolio's asset allocation annually and rebalance if necessary.
Look first to rebalance tax-advantaged accounts such as employer-sponsored plans and IRAs, where gains generated by a shift aren't subject to current taxes. If you rebalance taxable accounts, aim to minimize potential capital gains by selling assets the values of which have declined or remained unchanged.* Source: Vanguard Investment Counseling & Research.
- All investments are subject to risk.
- Consider consulting a tax advisor about your financial situation.