Shirley M. Mueller, MD
Shirley M. Mueller, MD
Shirley Mueller, MD is a physician turned financial consultant and investment educator who specializes in guiding clients, both one-on-one and in groups, about how to effectively self-invest using a simple and effective three-step approach

Tax-Smart Investment Strategies: Part II

Many financial advisors ignore tax efficiency when investing for their clients. In the end, the customer pays more in taxes than he should. This is a double whammy; having to pay asset-management and transaction fees, and then pay unwarranted taxes as well.

Fortunately, the ability to control one’s own portfolio negates this problem. Last week, I addressed the importance of investing the right types of securities in tax-advantaged savings accounts. In the second of my two-part series on minimizing taxes, we’ll look at investing in taxable accounts.

For example, if taxable bonds ideally should be held in a tax-advantaged account, tax-exempt bonds are generally considered more suitable for taxed accounts. Tax-exempt bonds such as municipal bonds have gotten bad rap recently, however, over the threat of local government defaults. Meredith Whitney, the head of Meredith Whitney Advisory Group, made headlines when she suggested in an interview with “60 Minutes” that there will be between 50 and 100 “significant” municipal-bond defaults in 2011, totaling “hundreds of billions” of dollars. It is worth noting that bond guru William Gross, the CEO of Pacific Investment Management Co. (PIMCO), disputes this, as do many others. Nevertheless, for those inclined to be conservative, minimizing or avoiding tax exempts for the time being could be prudent.

Large growth stock index funds are also good candidates for taxable investment accounts because they traditionally increase in intrinsic value over time and pay low dividends. For example, Vanguard Large Cap Growth exchange traded fund (VUG) has increased about 35% in value since its inception in 2003. It has a dividend of 0.85%. Compare this with typical investment yields in tax-advantaged accounts, which often range from 4% or more. Lower yields mean fewer taxes to pay in the taxable account. On the other hand, in the tax-advantaged vehicle, higher tax-deferred yields mean greater returns.

International, small capitalization and small value mutual funds or ETFs are next in line when considering yield and risk in taxable accounts. These investments can fluctuate more in intrinsic value (and are thereby more risky), but the dividend again is smaller than investments I recommend for tax-advantaged accounts. For example, Vanguard Small-Cap Value ETF (VBR) has a dividend of 1.90%, greater than the Vanguard Large Cap Growth, but smaller than the types of yields from investments I recommend for the tax-advantaged account.

Lastly, some people opt for tax-managed mutual funds to be held in taxable accounts. Though this is an option, it is something many could do themselves and thereby avoid higher manager fees and costs related to the turn-over generally created by them.  

As Warren Buffett says, “Investors should remember that excitement and expenses are their enemies.” Tax is an expense that can’t be legally avoided, but it can be diminished.

Read Part I of my two-part series on tax-smart investment strategies.
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