By Ron DeLegge

SAN DIEGO (ETFguide.com) - In one of my favorite Three Stooges episodes Curly wins $50,000 in a radio contest and the stooges move into Hotel Costa Plente. They buy new clothes, fine champagne and live like royalty. Shortly thereafter, they receive a Telegram informing them their $50,000 cash prize amounts to just a few hundred dollars because of taxes. They quickly realize they’ve been living beyond their winnings and that’s when the fun of trying to escape from Hotel Costa Plente begins.

Along similar lines, many investors are completely caught off guard by the tax consequences of their financial decisions. In many instances, people own investments that amount to nothing more than a big fat tax bill.

A 2009 Lipper study found that buy-and-hold investors with mutual funds in a taxable account surrendered between 1.13% to 2.13% of their annual returns over the past 10 years. In 2008, the tax bite to fund investors was around $5.2 billion and much lower than previous years because of the market’s decline. But that’s not a small amount considering buy-and-hold fund investors reinvest their distributions back into the funds they own. What does this mean for you?

It means that you should invest in a way that limits the adverse impact of taxes. The less you pay in taxes will mean more money in your own pocket.

Let’s evaluate three basic strategies for limiting your tax bill.

--Raise Your Tax Awareness Level
Fund investors need to have a realistic view of taxes. This begins with being acutely aware about the negative consequences of taxes from two perspectives: 1) The internal trading cost of fund holdings by portfolio managers and 2) The trading cost of mutual fund shares by you. “Tax consequences of trading certainly matter to investors, as more than two-thirds of mutual fund assets reside in taxable accounts,” said David F. Swensen author of Unconventional Success: A Fundamental Approach to Personal Investment (2005 Free Press).

Another related issue, pertains to holding periods. I’ll try not to put you to sleep.

Capital gains on investments are taxed according to how long you’ve held them. For example, a short-term holding period is defined as one year or less and gains are taxed at ordinary income tax rates. In contrast, long-term capital gains are taxed at lower rates and apply to investments held for longer than one year.

In 2003, the tax rate for long-term capital gains was reduced to 15% for all income tax brackets except the lowest two brackets. For 2010, the tax rate on eligible dividends and long term capital gains is 0% for those in the 10% and 15% income tax brackets. If you’re in a low tax bracket and you’re fortunate enough to be sitting on gains, take advantage of this tax savings bonanza!

If you’re not in a low tax bracket, you can still save a bundle on taxes by how you behave. Because capital gains are taxed at lower rates on investments held for longer than one year, it’s more tax beneficial to be a long-term investor as opposed to a short term investor. Knowing this can help you to greatly reduce your tax liabilities.

--Align Your Investments Correctly
Much emphasis on traditional portfolio building is put on asset allocation. The basic idea is to obtain an optimal mix of various asset classes, like stocks and bonds, which correctly matches your investment goals. Unfortunately, not enough emphasis has been placed on the importance of proper asset location.

Asset location involves coordinating the investments inside your taxable investment accounts and your tax-deferred retirement accounts (IRA, ROTH IRA, 401(k), 457, 403(b) etc.) with the purpose of obtaining lower tax consequences. Even the best of asset allocation plans can be severely undermined by improper or poor asset location. Good asset location involves holding the right asset classes in the right places. It also means knowing which ETF product structures offer the best tax-efficiency.

--Use the Right Financial Products
Most broad-based index ETFs are very tax-efficient, meaning they distribute little to nothing in capital gains. This is one of the reasons index ETFs should be the foundation of most investment portfolios.

Last year, Morningstar conducted a survey on capital gains distributions for stock ETFs across 27 broad-based indexes. The study showed only two ETFs made capital gain distributions over the past 5-years while just one ETF made distributions over the past 10-years. Popular funds like the SPDR Dow Jones Industrial Average ETF (NYSEArca: DIA), iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM), iShares MSCI EAFE Index Fund (NYSEArca: EFA), Vanguard Total Stock Market ETF (NYSEArca: VTI), and the SPDRs S&P 500 (NYSEArca: SPY) continue to lead the pack in low tax distributions.

Not all index funds are necessarily tax-efficient. “A number of widely known funds suffer from poor structures that lead to excessive turnover, high costs, and low tax efficiency,” observes Swensen. As a result, it behooves you to make sure you choose index funds and index ETFs with the right financial structure.