1. Invest in Tax-exempt Funds
If you want to hold money market or bond funds in your taxable accounts, consider choosing tax-exempt municipal money market or bond funds. Interest paid on bonds issued by a state or local political subdivision (that is, municipal bonds) is generally exempt from federal income tax. The interest may also be exempt from state and local income taxes, provided the bonds were issued in the state in which you reside. Because the income dividends from municipal money market and bond funds generally aren't taxable, these funds typically have lower yields than those of taxable money market and bond funds. Even so, if you're in one of the upper marginal tax brackets -- and especially if you live in a state or locality with high income tax rates -- municipal money market and bond funds are likely to provide you with higher after-tax income than would taxable funds with similar characteristics. Although the income from a municipal bond fund is exempt from federal tax, you will pay tax on capital gains realized from a fund's trading or from the redemption of shares. For some investors, a portion of the fund's income may be subject to the alternative minimum tax. Income may also be taxed by state and local governments. Keep in mind that even tax-exempt funds can distribute short- or long-term capital gains, which would be subject to tax. In addition, for some shareholders in tax-exempt funds, a portion of the income may be subject to the alternative minimum tax. The higher your tax bracket, the more likely it is you'll benefit from municipal bond funds. To be certain whether they're the best choice for you, check the bond fund's taxable-equivalent yield.

2. Consider Tax-Efficient Funds
Today's investors have more tax-efficient funds to choose from than ever before. Some of these funds are billed as "tax-managed" and focus specifically on providing high after-tax (rather than pretax) returns. Even funds that don't claim to be tax-managed can still be relatively tax-efficient -- especially if their managers use certain strategies. Here are some signs of tax efficiency you can look for in any fund's prospectus:

• Low turnover. Managers can reduce realized capital gains by minimizing turnover -- their buying and selling of securities. Index funds, which buy and hold the securities in a specific market index or a representative sample of the index, tend to have lower turnover rates than actively managed funds, and so generate fewer capital gains. For example, an all-market stock index fund can have a turnover rate of less than 10%. (This isn't true for all index funds, so be sure to check the turnover rate, reported in the fund's prospectus or annual report.) Some actively managed funds, on the other hand, have turnover rates of 200% or more. In general, look for a turnover rate that's around 20%.
• Redemption fees. Managers can charge redemption fees to discourage shareholders from redeeming their shares soon after investing. Redemptions can cause a fund's manager to have to sell the fund's holdings, thus triggering capital gains for the remaining shareholders. If a fund you're considering charges a redemption fee, make sure it's paid to the fund, where it serves to compensate the fund shareholders -- not to the fund management company, where it doesn't benefit fund shareholders at all.

• HIFO (highest-in, first-out) accounting. When selling shares of a security, fund managers can keep the taxable gain passed through to shareholders as low as possible by first selling the highest-cost shares. HIFO can be a much more tax-efficient strategy than FIFO (first-in, first-out), in which the first shares purchased are the first sold.
• Loss harvesting. When managers sell securities that have lost value at the same time they sell securities that have increased in value, they can offset or reduce taxable gains.

3. Buy and Hold Your Investments
You can invest in the most tax-efficient fund in the world, but if you trade it regularly -- even as often as every 2 or 3 years -- you'll offset most of the tax benefits. Limiting sales in your taxable accounts will reduce the capital gains you realize from selling shares and preserve more of your after-tax return. For example, if you sell shares you've held for a year or less, any resulting capital gains will be taxed as ordinary income at your marginal income tax rate (up to 38.6% for 2003). If you hold those shares for more than a year, any gains will be taxed at a capital gains rate that's substantially lower (a maximum of 20% for 2003) than your income tax rate. Taxpayers in the 10% and 15% income tax brackets pay 10% on long-term capital gains, unless the security was held for more than 5 years. In that case, the tax rate is 8%. Of course, even buy-and-hold mutual fund investors usually can't avoid taxes altogether. That's because the interest or dividends paid by the securities held in their fund and the capital gains the fund realizes by buying and selling its securities are taxable to fund investors. There may even be times when your account loses value but -- because of dividends paid or securities held in the fund -- you still receive distributions and, thus, a tax bill for the year. When you buy and hold, you can keep your taxes to a minimum.

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