Do you think about taxes before you make investments?  You should.  Controlling your tax bill is easier when you think about taxes before you "buy".  What I'm talking about is tax efficient investing.  Today, I'm going to discuss the first level of tax efficient investing...selecting tax-efficient Mutual Funds/ETFs.

When you look at a Mutual Fund's (or ETF's) advertising materials you will almost always see the fund's returns.  You will see the same or similar numbers on many "independent" fund ranking sites.  But, what you're not seeing is the after-tax return and the difference can be significant.

This comes down to how the fund earns its money.  If a fund is actively managed, then normally there are more transactions and capital gains are recognized throughout the year.  These capital gains will be distributed to the mutual fund shareholders in December and those distributions are taxable (assuming the funds are held in a taxable account).  On the other hand a passive/index fund will not have as many transactions and have lower capital gains to distribute in December.

So, let's take a look at a couple of examples.  I'm not recommending any of these funds, but have selected them only to illustrate the point.  Let's look as some funds using one-year return as a determining factor (again, not recommending that you use one-year return as a determining factor but some do).  Two asset classes that are illustrative are Large-Cap Blend and Small-Cap Value.

Large Cap (Name of Fund/Return)

Dreyfus Large Cap Equity Fund                 27.36%

Schwab US Large Cap ETF                       24.77%

Small Cap Value (Name of Fund/Return)

Hotchkis & Wiley Small Cap Value Fund    32.06%

Vanguard Small Cap Value ETF                 28.23%

Using the returns above, you might be tempted to select the fund listed first.  If you're putting these funds in a taxable account, that might be a mistake.  Let's look at the same funds' after-tax return (after tax returns are based on the highest tax bracket).

Large Cap (Name of Fund/After-tax Return)

Dreyfus Large Cap Equity Fund                   19.89%

Schwab US Large Cap ETF                         23.77%

Small Cap Value (Name of Fund/After-tax Return)

Hotchkis & Wiley Small Cap Value Fund      22.04%

Vanguard Small Cap Value ETF                   27.20%

In both cases, the higher earning fund (due to portfolio turnover) distributed more earnings in December and as consequence of the resulting taxes, their returns were reduced by almost 1/3 to below the after-tax return of the index ETFs.

What can you do about it?  First ask your advisor if he/she considers tax efficiency when he/she builds your portfolio.  If not, ask why and then ask yourself why he/she is your advisor.  (By the way, C.L. Sheldon always consider taxes when building portfolios).  If you don't have an advisor and don't want one, information on funds' tax efficiency is available through Morningstar.

Tax efficiency matters.  There is a concept called "Tax Alpha" which basically describes the additional return that can be achieved through effective tax-efficient investing.  Some studies put "Tax Alpha" at around 2%.  Something to think about...

Managed wisely, life insurance can be an effective component of an estate planning strategy.(1) Under the IRS's Unlimited Marital Deduction provision, assets may pass free of estate tax from one spouse to another -- provided he or she is a U.S. citizen -- no matter what the amount. But if your beneficiary is someone other than your spouse, a child for example, he or she could inherit a hefty estate tax bill. While the IRS allows up to $5.34 million to pass to heirs free from federal estate tax in 2014, any amount above that could be taxed at a rate of up to 40%.

With an exemption that sizeable, you may not be concerned about estate taxes. But if much of your estate is illiquid -- that is, if much of it is held in real estate or a business -- then you may want to consider setting aside assets held outside of your estate to cover the estate tax bill. Life insurance may help you to pay estate taxes while preserving more of your wealth for future generations.

The Tax Facts

As long as you don't own the life insurance policy and did not retain control over it within the last three years of your life, the proceeds generally will not be treated as part of your estate and therefore will not be subject to estate tax.

One strategy for capitalizing on the tax benefits of life insurance is to establish an irrevocable life insurance trust, which serves as both owner and beneficiary of a life insurance policy. A trust can help keep the proceeds of the policy out of your estate, thus avoiding federal estate tax. In addition, when setting up the trust you can name one or several beneficiaries, or trustees. Trustees can use the proceeds of the policy to pay estate taxes and estate settlement costs, while the remaining monies, if any, can be distributed to beneficiaries free of income tax.

If you already own a life insurance policy that qualifies for inclusion in your estate, you may be able to gift the policy to a beneficiary. If, however, the cash value of the policy on the date of transfer is more than the $14,000 gift exclusion allowed per individual, per year (in 2014), the transfer may be subject to gift tax. It may be possible to circumvent the gift tax by naming more than one beneficiary. This would allow you to potentially transfer up to $14,000 per beneficiary without incurring gift taxes.

Devise a Plan That's Right for You

Life insurance is just one of the many tools that could be used to help you pass your estate on to your loved ones effectively. Your financial advisor, accountant, and/or tax or legal advisor can help you evaluate your situation and assess which tools and strategies may be appropriate for your needs.

This article offers only an outline; it is not a definitive guide to all possible consequences and implications of any specific trust option. For this reason, be sure to seek advice from knowledgeable legal, tax, and financial professionals.

Source/Disclaimer:

(1) Life insurance policies are subject to substantial fees and charges. Death benefit guarantees are subject to the claims-paying ability of the issuing life insurance company. Loans will reduce the policy's death benefit and cash surrender value, and have tax consequences if the policy lapses.

Required Attribution

Because of the possibility of human or mechanical error by Wealth Management Systems Inc. or its sources, neither Wealth Management Systems Inc. nor its sources guarantees the accuracy, adequacy, completeness or availability of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. In no event shall Wealth Management Systems Inc. be liable for any indirect, special or consequential damages in connection with subscriber's or others' use of the content.

© 2014 Wealth Management Systems Inc. All rights reserved.

Figuring Out How Much You Need In Retirement

At some point, almost everyone asks this question: How much do I have to save for retirement? Of course, there's no easy answer, but what may be even more disconcerting is the possibility that this may be the wrong question. It might be more beneficial to figure out how much income you will need annually in retirement than it is to pinpoint the amount you should try to set aside....Read more here.

Should You Borrow Against A Life Insurance Policy?

William Shakespeare famously wrote in "Hamlet," one of his classic tragedies, "Neither a borrower nor a lender be." But sometimes borrowing can't be helped. You may need cash in a hurry and have few other affordable options. In that case, you might consider borrowing funds from a somewhat unusual source: your life insurance policy...Read more here.