If you want to minimize receiving taxable distributions from mutual fund investments, tax-efficient funds should be considered for your investment portfolio.
In tax-efficient investing, the focus is not on what you earn but what you are able to keep. The objective is to produce the best after-tax returns. Such mutual funds apply to investments outside of IRAs, 401(k)s and other tax-deferred accounts.
According to the global investment management firm T. Rowe Price, tax-efficient mutual funds are becoming more and more popular despite recent cuts in tax rates.
Nobody likes to think about taxes, after all. And investors who want to minimize taxes are forced to think about them constantly: They have to monitor their portfolio holdings, distributions and potentially extensive transaction records.
However, Don Peters, who manages several tax-efficient portfolios at T. Rowe Price, says tax-efficient investing means more than just avoiding taxes.
"Successful tax-efficient investing is building and managing a portfolio of securities that you can hold for the long term and that can generate good long-term after-tax performance," he said.
There are some misconceptions about tax-efficient investing, however. For one, some believe that you should avoid buying the stocks of companies that pay dividends, which will then be taxed. It's not that simple, Peters says.
Another misconception is that investors should never sell their holdings, thereby avoiding paying a sizable capital gains tax. Peters says investors should not let "tax phobia" interfere with smart investment decisions.
"The selling decision can be very difficult, particularly if you have a sizable unrealized capital gain," Peters said. For a realistic tax-efficient investment strategy to make sense, he said, gains should be minimal but not zero.