How To Tax-Proof Your Portfolio Source: by Olivia Barbee Talk about mutual funds and taxes, and you enter a funhouse where nothing is as it seems. How many times have investors bought funds that had been tax efficient in the past, only to be immediately hit with a large taxable distribution? Myriad factors--only some of which the manager can control (and none of which the investor can control)--determine a fund's tax efficiency. Instead of frustrating yourself by trying to find a tax-efficient fund, turn yourself into a tax-efficient investor by following these seven steps. 1. Hold funds from tax-inefficient groups in tax-sheltered accounts. Some types of funds are inherently tax-inefficient. All high-yield bond funds, for example, throw off scads of income that's taxed at your highest marginal income-tax rate, not at the often-lower long-term capital-gains rate. It's best to stick such funds into tax-deferred accounts, such as an IRA or a 401(k). 2. Sell specific shares. When you sell shares in a fund, your taxable gain is determined by the sale price minus your cost basis in the fund. Let's say you dollar-cost averaged into a fund, thereby picking up shares at different prices. What's your cost basis when you sell? For most fund companies, the default cost basis is the average of the cost basis on your individual shares. Many investors can save on taxes by identifying specific shares to be sold. Suppose, for example, that your average cost basis in a fund is $10, but you recently purchased individual shares with a cost basis of $16. If your fund now sells for $20 per share, you'd have a much lower taxable gain if you sold the shares with the $16 cost basis, rather than using the default $10 cost basis. The specific-shares method involves a lot more record-keeping and hassle than the default average-cost method, but the tax savings may be worth it. Unfortunately, this rule applies only to funds on which you've never sold shares using the average-cost method, because once you use that method on a fund, the IRS requires that you continue to use it. 3. Sell purposefully. Suppose you own a fund that's been a longtime loser. In fact, it has underperformed to the extent that you have a loss on your investment. Think about using that loss to your advantage. Sometimes we hang on to funds that we don't particularly like and that aren't performing well because we want to "break even" on our investment. Nuts to that. Use the loss on that fund to offset gains elsewhere in your taxable portfolio. 4. Shelter like crazy. Take full advantage of all the tax-deferral options available to you, whether they are 401(k)s, 403(b)s, or IRAs. Once you've contributed the maximum amount to those accounts, go to number 5. 5. Buy tax-managed funds for nonsheltered accounts. A well-run tax-managed fund will keep taxable distributions to a bare minimum. Vanguard and T. Rowe Price both offer diverse lineups of tax-managed funds. 6. Go the direct route. The most tax-efficient investment may not be a fund at all, but a stock. When you put together a stock portfolio, you have complete control over when to sell a holding, except in cases when the company you own is taken over by another. 7. Steer clear of funds that've been horribly tax inefficient for taxable accounts. While a fund's tax efficiency doesn't always repeat, it's probably best to steer clear of funds with poor tax efficiency versus their peers. You can find information about a fund's tax efficiency on its Quicktake Report. Simply click on Trailing Returns, and scroll down to Tax Analysis. Following these guidelines won't guarantee that you'll never pay a penny in taxes, but the rules will allow you to sensibly maximize your aftertax return. Hooray to that. Stock and mutual fund data and analysis available at