Meg Handley

Stocks and bonds rewarded investors with relatively robust performance in 2010, which means it's more likely that your mutual funds ended the year with gains instead of losses. That's great news for the net value of your portfolio, but combined with the market's strong start this year, the prospect of having to pay more in capital gains taxes in the future is not as appealing.

By law, fund managers must pass on almost all gains their fund accumulated during the year to investors in the form of capital gains distributions. Investors must pay taxes on those gains regardless of whether they choose to reinvest in more shares of the fund. Depending on how long you hold an investment, capital gains are taxed differently; long-term capital gains rates apply to investments held for longer than one year, while short-term capital gains taxes affect investments held for less than a year.

Despite last year's gains, Morningstar analyst Christopher Davis says the tax burden on mutual fund investors should be fairly light, mostly because fund managers still have substantial losses on their books from 2008 that can be used to offset capital gains achieved in 2010. (Mutual funds can carry forward losses for up to seven years.) According to the Investment Company Institute, mutual funds passed on just $3.4 billion in capital gains taxes during the first nine months of 2010, comparatively less than the $6.2 billion during the same period in 2009, and significantly less than the $132 billion investors were stuck with for the whole of 2008.

While investors might not feel the bite of a bigger tax bill this year, Davis says the effects of a stronger, sustained economic recovery might mean the days of diminutive capital gains distributions are numbered. "Some funds have made so much money since the bottom, so a lot of those tax losses that they were able to use don't exist anymore -- they've been mostly wiped out," he says. "Presuming things continue on pace, I think that you could expect to see a more normal environment for taxes."

Furthermore, there are no guarantees that today's capital gains tax rates -- recently renewed by President Obama -- will remain at current levels after their scheduled expiration in 2012. "The only saving grace we have right now is the lower capital gains rates. Chances are, that's going to go away sooner or later," says Cindy Hockenberry, tax knowledge center supervisor at the National Association of Tax Professionals. "Will they change capital gains rates to be something more, or still have a soft spot for investors? After 2012, it's a crapshoot."

Experts say tax considerations should never direct your investment decisions, but there are some strategies you can use to minimize Uncle Sam's impact on your portfolio. U.S. News asked experts for some tax-friendly techniques that could save you money on your tax bill next year:

Location is key.

As with real estate, making sure your investments are in the best place is the first big step toward avoiding unnecessary taxes. For example, consider housing more aggressive mutual funds in a Roth IRA. Because your contributions to a Roth IRA are taxed upfront (as opposed to traditional IRAs or 401(k)s, which are taxed as income upon withdrawal) you'll never pay income tax on the growth of your investments, whether it comes from dividends or capital gains. "It's an ideal spot for fast-trading funds that might generate a lot of gain," Davis says. If you put a fund that derives most of its gains from capital appreciation in a 401(k), you'll ultimately end up converting those capital gains (which are taxed at a lower rate) into income (which is taxed at a higher rate) when you withdraw from your 401(k), Davis says. "In a Roth, investors don't pay taxes on capital gains, so it makes more sense to put high-returning investments there," he adds.

Look for low turnover.

When a manager sells a security from a fund, there is the potential for investors to incur capital gains. Managers of funds with longer-term outlooks tend to buy and sell securities much less frequently, which translates into lower turnover and fewer taxable capital gains. You can check turnover rates on most fund companies' websites or by visiting Morningstar . Generally, a turnover rate of 10 percent or below is considered tax-efficient. Also, most index funds, which track specific market indices, are generally a good bet for tax-conscious investors, Davis says.

Consider ETFs.

Exchange-traded funds have been gaining popularity among investors, and not only because they tend to have lower annual fees than mutual funds. By design, ETFs are generally more tax-efficient as well.

Most ETFs track indices, and because much of their day-to-day trading occurs only between shareholders and doesn't affect the underlying securities, turnover and capital gains remain relatively low. That paradigm is much different than the scenario with mutual funds, in which fund managers might have to sell underlying securities (sometimes at a loss, sometimes at a gain) in order to satisfy shareholder redemptions.

"Let's say you own an ETF and want to sell it. You go into your Schwab account and you sell the ETF shares to another shareholder," says Matt Hougan, president of ETF analytics at IndexUniverse. "There's no contact back to the ETF company. When investors sell, it doesn't force the ETF company to sell securities and incur capital gains."

Hougan cites iShares, the largest family of ETFs, as an example. According to its website, in 2010 iShares made capital gains distributions for only five ETFs (all bond funds) out of the 218 funds the company offers. "Equity ETFs, by and large, never pay capital gains distributions," Hougan adds.

Try a tax-managed fund. Some mutual funds aim to limit shareholders' tax burden by using a variety of active-management strategies to minimize taxes. These funds tend to have long-term outlooks and harvest losses to offset gains to avoid capital gains taxes. They also tend to avoid dividend-paying stocks.

Davis recommends Vanguard Tax-Managed Growth and Income (symbol VTGIX), which mimics the S&P 500, but pays special attention to tax considerations. For instance, although the fund has similar sector and stock weightings as the S&P 500, management might sell certain positions at a loss to offset gains from better-performing holdings. As a result, the fund's weightings vary slightly from its benchmark.

Davis also likes Vanguard Tax-Managed Capital Appreciation (VMCAX), which mimics the Russell 1000 index. A feather in the cap of this tax-managed fund: It has never distributed a capital gain in its 16-year history, according to Morningstar.

Wait to buy.

Most funds dole out capital gains distributions late in the year, so avoid picking up a fund if management plans to pay out a distribution. That way, you can avoid paying taxes on gains you haven't yet participated in. Also, it's helpful to know a little bit about the balance sheet of a prospective fund. If it has significant losses to carry forward to offset gains in the future, it could be tax-efficient going forward.


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