One Way to Shrink Your Taxes: Buy Mutual Funds, ETFs

Nathan Sonnenberg of Glassman Wealth Services for AdviceIQ @ TheStreet.com writes: After tax season, when they realize exactly how much they paid at home, a number of my friends, colleagues and clients asked me what they should do to reduce their burden next year. While I'm not a tax professional, I certainly pay attention to tax rules and rates regarding investing.

My short answer to their question was: Create a portfolio of low-fee, thoughtfully constructedstock index mutual funds or exchange-traded funds. Yet not all of them do the job for you. Here's how to find the right one.

An index mutual fund is a passively managed fund that tracks the performance of a certain index, such as the Dow Jones Industrial Average, or a broad bond or commodity index. An ETF is similar to an index mutual fund, but is traded on the stock exchanges, like a stock. Rather than buying all of the stocks in the Dow Jones or Standard & Poor's 500, you can simply own an ETF that tracks that index.

Because index mutual funds or ETFs are not actively managed, their fees are often low. Also, their low turnover — how frequently stocks are bought and sold within a portfolio — provides tax benefits as excess activity creates the potential for more taxable events.

Consider these three aspects before buying an index fund or ETF:

1. Market exposure. Decide what you want to own. This is obvious, but not simple. Choosing from the broad number of stock index providers can be overwhelming (the Dow, S&P 500,Russell 2000, MSCI, FTSE). Therefore, it's important to understand what markets, countries, regions, industries, sectors and stocks the index fund you buy contains. Is your goal to own large stocks, small stocks or both? Do you want U.S. stocks, international, emerging-market or all of the above?

Just as important, the fund you choose should adhere closely to its benchmark index. The more closely the investment matches that of the desired exposure, the better. Websites such as ETF.com and Morningstar.com provide great resources. 

2. Fees. Like actively managed mutual funds, every index fund and ETF have management fees. These range from more than 1% to as low as 0.04% per year. The lower your investment fees, the more of the returns you keep.

Another factor affecting cost is liquidity or, put simply, how easy it is to buy and sell the investment. With mutual funds, this is not an issue because they are bought or sold at the end of each day. For ETFs, which are traded like stocks, their liquidity is a more important issue. If an ETF is thinly traded, to buy or sell it may be more costly.

3. Tax cost ratios. This measures how much the taxes you pay on distributions reduce a fund's return. The lower this number, the better. Morningstar, an industry leader in tracking investments, offers this information for free.

Now that you know what you should keep in mind before investing in index mutual funds or ETFs, here are four investments in different markets for your consideration:

Broad U.S. stock market: Schwab U.S. Broad MarketPortfolio: Diversified exposure across 2,000 large and small-capitalization U.S. stocks
Current yield: 1.75%
Expense ratio: 0.04%. Three-year tax cost ratio: 0.76

S&P 500: Vanguard S&P 500 Index Fund
Portfolio: Seeks to track the performance of the S&P 500 stock index.
Current yield: 1.68%
Expense ratio: 0.17%. Three-year tax cost ratio: 0.49

International stocks: Vanguard Total International Stock
Portfolio: Seeks to track the performance of a broad, international index made up of approximately 5,500 stocks (83% in developed countries, 17% in emerging countries).
Current yield: 3%
Expense ratio: 0.22%. Three-year tax cost ratio: 1.01

Emerging market stocks: iShares Emerging Markets
Portfolio: Seeks to track the performance of the MSCI Emerging Markets index, made up of of more than 800 stocks in 16 countries.
Current yield: 1.57%
Expense ratio: 0.67%. Three-year tax cost ratio: 0.46

If you want broad stock market exposure in your portfolio, consider these. They are very effective at accomplishing the dual objectives of high tax efficiency and low cost.