Many, perhaps most, investors agonize over their asset allocations without paying any attention to the location of those assets once an allocation is decided upon. This is unfortunate, because in many cases asset location is as important as asset allocation .  Certain types of mutual funds and especially asset classes are more tax-efficient than others.  For tax-efficiency information on specific funds you may be considering, I recommend signing up for a free Morningstar account and using their tax-analysis feature.

So what types of mutual funds are best for your taxable accounts and which should you avoid at all costs? The rules are relatively simple.

Criteria For An Ideal Taxable Investment

• Long-term returns come almost completely from price increases as opposed to short-term capital gains, dividends, or interest payments
• Distributes little or nothing in the form of taxable interest or dividend payments
• Very low turnover in order to minimize taxable gains
• Equity-basedsure, municipal bond funds pay tax-free interest, but bonds in general should go in your tax-deferred accounts such as your 401k/IRA. You should only ever own bonds in a taxable account if you have absolutely no room anywhere else.

Three Best Mutual Funds For Your Taxable Account

As you probably know if youve been reading this blog for a while, Im a huge Vanguard fan. As it turns out, index funds are some of the most tax-efficient funds around, so its no surprise they top the list here. The other top mutual fund companies also offer quality index funds, especially Fidelity.  Any broadly-diversified index fund would do well so long as the expense ratio is relatively low.  As mentioned above, you can use Morningstars tax-analysis feature to research the tax-efficiency of pretty much any mutual fund in existence expressed as a percentage of fund assets.  For instance, a tax-cost ratio of 0.2% means that, on average, that particular funds investors have had to pay 0.2% of their portfolios value out every year to Uncle Sam in the form of taxes on gains.  Needless to say, it pays to research your funds tax-cost ratio before investing.

Vanguard Total Stock Market Index Fund (VTSMX ) The grand-daddy of them all, this index fund owns almost every stock there is to own in America, resulting in low turn-over and a very high degree of tax-efficiency. Every investor should own this fund as a core taxable holding, in my opinion.

Vanguard Total World Stock Index (VTWSX ) This fund covers both domestic and foreign large-cap stocks in a single fund. Its admittedly a bit low on the small-cap exposure, but for most investors wanting broad exposure to the entire equity universe in a tax-efficient package, that wont matter. Initially I had declared I wouldnt be buying this fund in my taxable account, but the simplicity and tax-efficiency of it just might change my mind.

Vanguard Tax-Managed Capital Appreciation (VMCAX ) This fund is technically not an index fund, although it does adhere to many indexing principals. From the prospectus, it starts with the index and then removes some of the higher-yielding stocks in order to improve tax-efficiency. This may not be a strategy everybody agrees with, but in the past has yielded very nice results. One note: this fund focuses a bit more on mid- and small-caps than the above index funds so it may be more volatile over time.