When it comes to mutual fund investing, it's not what you earn that matters as much as what you manage to keep.

Indeed, the net return on your portfolio can be hugely impacted by how much you surrender each year to Uncle Sam.

Not convinced?

Consider hypothetical taxable investments of $10,000 into two mutual funds that both have pretax total returns of 10% per year. One fund, however, has an after-tax return of 9%, and the other has 7%.

After 30 years, the investment with the smaller tax liability grows to almost $132,677 after taxes -- roughly 75% more than the $76,123 produced by the more heavily taxed fund.

Investment Annual pretax return After-tax return Value of investment after 30 years

$10,000 10% 9% $132,677
$10,000 10% 7% $76,123

Despite the clear advantage of tax efficiency, however, the significance is often lost on individual investors, as it is for many managers of actively traded equity funds whose only focus is pretax returns.

For those who own securities exclusively in tax-sheltered accounts, such as individual retirement accounts and 401(k)s, the need to manage tax liability is minimal. But those with both taxable and tax-deferred investments should take the threat of tax drag on performance seriously -- especially those in the upper income brackets, says Mark Luscombe, principal analyst for tax accounting group CCH in Riverwoods, Ill.

"(Managing tax liability) becomes more significant the higher your tax rates are and especially for those subject to the new, higher tax rates in 2013," says Luscombe. "There are new incentives to do something about it."

Effective this year, couples earning more than $250,000 may be hit by a new 3.8% Medicare surtax on net investment income, while joint filers with taxable income greater than $450,000 will face a 39.6% top marginal income tax rate, plus a bump to 20% from 15% on qualified dividends and long-term capital gains.
Your tax liability

Mutual funds that are not held in a tax-advantaged account produce taxable distributions each year in the form of dividend income, interest generated from bond funds and capital gains, created when securities held within the fund are sold.
As an investor, you will also owe capital gains when you sell shares of the fund at a profit.

Proceeds from investments held for one year or less are considered short-term capital gains and are taxed more heavily at your ordinary income rate, while securities held longer than one year are considered long-term gains and taxed at 20% for those in the highest 39.6% tax bracket.

Those in the 25% through 35% brackets pay 15% tax, and those in the lowest two brackets -- 10% and 15% -- pay zero.
Asset location vs. allocation

While asset allocation -- the process of determining the right mix of stocks, bonds and cash -- is your first order of business in portfolio planning, where you park those securities within your portfolio can make a big difference in your tax liability and long-term returns, says Maria Bruno, a senior investment analyst for The Vanguard Group.

"Asset allocation is the primary driver, but asset location becomes significant as you implement that allocation," she says. "It's very important when you have different accounts to know what types of assets to allocate where."

Generally speaking, your most tax-efficient funds are best reserved for your taxable brokerage accounts, says Bruno. Those include investments that do not produce a high yield, such as total market index funds, municipal bonds and tax-managed funds.

Conversely, actively managed funds, which may distribute capital gains in addition to dividends, and narrowly focused index funds belong in tax-deferred accounts such as an IRA, 401(k) or variable annuity. So, too, do taxable bond funds, which include high-yield bond funds, Treasuries and Treasury inflation-protected securities, or TIPS, since dividends are taxed as ordinary income.

The Roth advantage

Christine Fahlund, a senior financial planner and vice president with T. Rowe Price, notes that placing investments in a Roth IRA is another effective way to lower your future tax bill -- especially for younger investors.

Contributions to a Roth IRA are not tax-deductible since they are funded with after-tax dollars, but the earnings grow tax-free. With a traditional IRA, pretax contributions are deductible and benefit from compounded growth, but distributions upon retirement are taxed as ordinary income.

All else held equal, says Fahlund, Roth IRAs are a better bet for tax-conscious investors.

"We feel very strongly that as soon as you can live without all or some of the income tax deduction you would receive (by making contributions to a traditional IRA), it is to your benefit to contribute to a Roth," she says. "When the money comes out, it's all yours."

"If someone is really concerned about paying taxes, they might consider a portfolio of only index funds, but we prefer the 'core and explore' method," says Justin Sinnott, a Seattle-based financial adviser for Charles Schwab & Co.

The investment strategy of core and explore consists of using index funds for efficient markets and actively managed funds for inefficient markets.

Growth-oriented small-cap and international mutual funds are two examples of inefficient markets, says Sinnott, since financial data are less readily available on the companies they invest in. Thus, managerial expertise is required to outperform.

Large-cap funds, by contrast, are more liquid and more transparent, requiring less hands-on maintenance. As such, notes Sinnott, they are generally best suited for the index fund portion of an investor's portfolio.

Tax-managed mutual funds are another option.

Managers in such funds keep their tax drag low by reducing turnover, purchasing tax-free or low-tax securities, avoiding dividend-paying stocks, and using losses to offset capital gains (a practice known as harvesting losses).
All that maneuvering, however, doesn't come cheap.

Michael Rawson, a fund analyst for Morningstar, notes tax-efficient funds tend to be pricier than similar funds from the same provider.

"It really needs to be worth your while to pay for that service," says Rawson, adding that such funds are best suited to taxable accounts for those concerned about taxes.

From a tax-efficiency standpoint, index exchange-traded funds are also often described as a better bet than their mutual fund counterparts, partly because they keep turnover low but also because they produce fewer capital gains using a mechanism known as "in-kind redemptions."

Indeed, many ETFs require authorized participants to exchange shares for a basket of securities rather than cash, allowing the fund to raise cash without having to sell securities.

Here again, however, Rawson warns that not all ETFs are more tax-efficient than mutual funds.

"Tax efficiency is based upon good portfolio management, not the structure of the fund," he says.
“If someone is really concerned about paying taxes, they might consider a portfolio of only index funds, but we prefer the 'core and explore' method.”

Time your purchase

When buying dividend-paying mutual funds, the tax-conscious investor should also be mindful of year-end distribution dates.

Why? Mutual funds are required to distribute at least 98% of their income and gains to shareholders each year, prompting many to make large dividend payments in December.

In tax-deferred accounts, this won't make any difference to the investor. However, in taxable accounts it will because these distributions are treated as income, even if the investor reinvests them in more shares instead of receiving them in cash.

"If you're buying a mutual fund between September and November, check to see whether it's paying a big capital gains distribution, and if it is, you might want to wait until after (the distribution)," says Catherine Taylor, vice president and counsel of the corporate tax division for Ameriprise Financial in Minneapolis. "You don't want to 'buy the dividend.'"

Mutual fund investors who have assets in both taxable and tax-deferred accounts can better their odds of enjoying a comfortable retirement by taking an interest in tax efficiency.

"In the markets, there are many factors that are outside of an investor's control, but one area where investors can have a direct impact on performance is tax planning," says Rawson.