Tax-saving investments

Points to know

• Investments that minimize trading activity and offset gains with losses may result in a lower tax bill.
• Some investments are exempt from taxation altogether.

Index mutual funds & ETFs

Index funds—whether mutual funds or ETFs (exchange-traded funds)—are naturally tax-efficient for a couple of reasons:

• Because index funds simply replicate the holdings of an index, they don't trade in and out of securities as often as an active fund would. Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.
• Since index funds have to buy new lots of securities in the index every time investors put money into the fund, the fund generally has hundreds or thousands of lots to choose from when selling a given security. This gives the fund manager flexibility to sell lots that have the lowest tax bite.
• These funds will only sell their complete holdings of a specific security if the index itself removes the security, which is a good thing for investors, since such sales can result in large capital gains.

And because of the way they trade, ETFs may have an additional tax benefit.

When you sell shares of an ETF, you're selling to another buyer as opposed to the fund company. This means the fund itself usually isn't involved in the transaction and doesn't have to sell any securities, potentially triggering capital gains.

Tax-managed stock funds

Some mutual funds are managed specifically to minimize the investors' tax burden, using strategies like:

• Avoiding dividend-paying stocks.
• Offsetting capital gains with losses.
• Holding stocks for an extended period to avoid short-term gains.

Tax-managed funds are usually more expensive than comparable funds that don't have that additional layer of tax management. So they'll probably make sense for you only if you're in a higher tax bracket.*

Municipal bonds & bond funds

Income from municipal bonds, which are issued by state, city, and local governments, is generally free from federal taxes.** These bonds are often called "tax-exempt bonds." Municipal bond income is also usually free from state tax in the state where the bond was issued.

Because they offer this special tax treatment, these bonds generally give you lower interest rates than comparable taxable bonds. So like tax-managed funds, they make the most sense for investors in higher tax brackets.

Learn more about the taxation of government bonds