The third priority of money is tax-efficient, wise investments. Wise investors know they will have to pay taxes and transaction fees on any investment they make, so they work to minimize these costs as much as possible. They also monitor their investments’ performances by comparing their returns after taxes and transaction fees to the appropriate benchmarks. The following are five important suggestions for investing tax-efficiently and wisely.

1. Know the impact of taxes: As an investor, you must be particularly concerned about the effects of taxes, because taxes are one of the largest expenses you will have to pay when you invest: every dollar you pay in taxes is a dollar that you will not be able to invest. To invest in a tax-efficient manner, you must understand how taxes influence your returns (capital gains, dividends, and interest). You can use the following formula to calculate your after-tax return. Your after-tax return is equal to your before-tax return multiplied by the result of one minus your marginal tax rate:

Return _{after tax} = Return _{before tax} * (1 – marginal tax rate)

Your marginal tax rate is the tax rate you pay on your last dollar of earnings. Your marginal tax rate encompasses your federal, state, and local taxes. It is important for you to know your marginal tax rate. Remember that different types of earnings are taxed differently. Bond interest is taxed at your marginal tax rate (as high at 35 percent), stock dividends are taxed at 15 percent, and unrealized capital gains (the capital gains on an asset that has not been sold yet) are not taxed at all until the asset has been sold.

To understand the impact of taxes, you must calculate the estimated after-tax return of each asset you are considering.

2. Replace ordinary income with capital gains: Capital gains are taxed at a much lower rate (15 percent) than ordinary income, which may be taxed at up to 35 percent. Earn as much of your income as possible in the form of long-term capital gains.

You can replace ordinary income with capital gains by using a buy-and-hold strategy when you invest. This strategy means that you hold on to your assets for as long as possible and do not trade in your accounts. By holding on to assets for extended periods of time, you defer earnings to the future and avoid paying taxes now.

3. Minimize turnover and taxable distributions: Minimize turnover on all assets and minimize taxable distributions on your mutual funds. Every time you sell an asset, you set up a taxable event (a transaction that has tax consequences). By using a buy-and-hold strategy, you minimize the impact of taxes and reduce your transaction costs as well.

The law requires that mutual funds distribute 90 percent of all capital gains and interest to shareholders annually. You will have to pay taxes and fees on these distributions, even if you do not sell your mutual fund. As an investor in a mutual fund, you must sometimes pay taxes because of the actions of the mutual fund’s portfolio manager.

You can minimize turnover and taxable distributions by selecting your mutual funds wisely. Invest in those funds that do not have a history of trading actively (i.e., funds that have low turnover or trading). These funds will reduce that amount of taxes you must pay each April.

4. Replace interest income with stock dividend income: Because of changes in the tax law in 2004, taxes on dividends from individual company stocks or stock mutual funds were reduced to 15 percent. However, interest earned on bonds or bond mutual funds is taxed at your ordinary income rate, which can be as high as 35 percent. If you put more emphasis on stock dividend income than interest income, you will potentially increase your portfolio’s return and pay less in taxes as well. These steps should only be taken if they are appropriate for your risk-tolerance level.

5. Invest tax free: If you are in a high marginal tax bracket, you can invest in assets that do not require you to pay federal or state taxes. For example, municipal bonds are federal tax free; they may also be state tax free if you are a resident of the state that is issuing the bonds. Treasury bonds are state tax free, and certain government savings bonds, such as Series EE and Series I bonds, are both federal and state tax free if the proceeds are used for tuition expenses.