Invest tax-smart

Making decisions about when to buy and sell can be hard enough when you’re managing your mutual fund portfolio, but smart investors consider tax implications, too.

If you’re new to investing and you bought a mutual fund in the last year, you might have been surprised to receive a tax bill in the form of a 1099-DIV – a statement outlining earnings from dividends and capital gains distributions.

If your fund distributes capital gains, you’ll get a 1099 even if you didn’t sell any shares or if your investment lost money. That’s because they’re generated by the actions of the fund manager, not the individual investor. When a portfolio manager sells securities at a profit during the year, it creates a gain which the fund is required to distribute to shareholders annually.

How much you’ll owe depends on how long the manager held the shares sold at a profit; short-term capital gains, assessed on investments held for less than a year, are taxed at a significantly higher rate than long-term capital gains.

There’s not much you can do about last year’s taxes. But the arrival of the 1099s might spur you to take tax-savvy measures in 2006.

You won’t be sorry if you do; Douglas Rogers, author of “Tax Aware Investment Management,” says being astute about taxes can boost your total return anywhere from 0.5 percent to 1.5 percent a year, depending on your portfolio. This might not have resonated with investors during the go-go years of the 1990s, but in the current environment, careful tax planning can have a huge impact.

“For someone young, just coming out of college, this can mean the difference between retiring at 65 or 60 versus maybe retiring at 75. So for the smaller investor, it’s absolutely critical,” said Rogers, a managing director and senior consultant at CTC Consulting Inc., a subsidiary of U.S. Trust Corp.

One easy thing mutual fund investors can do to protect themselves is to be careful about when they buy. Funds usually distribute capital gains at the end of the year, which means if you buy shares in November, and the fund pays a distribution in December, you’ll owe taxes for the entire year even though you’ve only owned the fund for a month. Most fund providers will announce the amounts and dates of capital gains distributions, so be alert when you buy.

Another strategy is to be thoughtful about where you hold your investments. If a fund you really like issues a big distribution, moving it to a tax-deferred account such as an IRA or a 401(k) could save you money. Be aware that investments that throw off lots of interest, such as REITs, REIT funds and fixed income funds, tend to generate higher tax bills, making them better-suited to tax-deferred accounts.

You can also be proactive about tax management when selecting the funds you plan to hold outside your tax-deferred accounts. Tax-free municipal bond funds are a good way to introduce a fixed-income element. Bargain hunters have long admired index funds and exchange-traded funds for their low expenses and tax-efficient structures.