It’s coming to the time of year when mutual funds will re-balance portfolios or sell off investments. Some of them constantly buy and sell securities. This is all well and good, but it certainly creates quite a bit of uncertainty come tax time. You never know what kind or amount of dividends you are going to get.
Well, 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 low tax rates for the past few years. And my guess is they will become more and more popular if all of the Bush era tax cuts are allowed to expire.

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.”

One way you can be more proactive in your own portfolio is to look at what is called the Turnover Ratio of a mutual fund. This measurement tells you how much (in percetage terms) of a portfolio is sold each year on average inside a mutual fund. The lower the number the better when it comes to tax-efficient investing.

Also keep in mind that if you can keep your taxes lower over the course of an investment, you may actually have a higher return. This is because taxes certainly come into play in your overall return. If an investment performs well, but you always have to pay taxes on distributions, your return would be lower compared to a comparable fund that does not have taxable distributions each year.

In the end, keep in mind that if you are proactive, you can lower your tax bill by investing in ore tax-efficient mutual funds.