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Tax-Efficient Funds: More Dollars per Gallon
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Writing a check out to the folks at the IRS is never a pleasant thing, especially if you're giving them part of your investment earnings. Fortunately, one breed of mutual funds, called tax-efficient funds (also known as tax-managed funds), might be able to help you limit Uncle Sam's take.
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Here's how they work. Your mutual funds must pay you almost all of the money they make from interest, dividends, or capital gains (money made from selling stock) in a year. That's called a taxable distribution (since you must pay taxes on that money). Tax-efficient funds keep their taxable distributions as small as possible, thus lowering the amount you pay in taxes.
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Tax-efficient funds can use several strategies to keep their distributions low. They avoid stocks that pay dividends. They don't sell their stocks very often. When they do sell stocks, they also might try to sell some that have lost money in order to offset those that have made money. These methods, and some others, keep your tax bill lower.
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The disadvantage of tax-efficient funds is that they tend to stick mainly with large-company stocks and tax-free bonds, making it hard to achieve an appropriate level of diversification in a retirement portfolio. Another option for those seeking to reduce their tax exposure is index funds. The managers of index funds generally don't trade very often and thus don't generate a lot of taxable gains.
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Although index and tax-efficient funds offer some tax benefits, you shouldn't let taxes drive your investment strategy. Your main focus should be on properly diversifying your portfolio, rather than avoiding the taxman.
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