Managing the taxes on your portfolio is a crucial part of investing, says The Oxford Club’s investment director Alexander Green. Following a few simple guidelines can significantly improve the returns you make. The priority is to put the most tax-inefficient investments - such as real estate investment trusts (REITs) and bonds - in a retirement plan.

This from The Daily Reckoning:

If you are voluntarily surrendering thousands of dollars to the IRS each year, you may feel like your investment portfolio is on a slow boat to China. Fortunately, you can tax-manage your portfolio to increase your real-world returns.

It’s not difficult. Here’s what you need to know…

Your annual tax liabilities will depend on both your tax bracket and how much of your portfolio is held outside of qualified retirement plans. I’m going to run through a few different scenarios, allowing you to easily adopt the strategy that is closest to your own personal situation.

Let’s start with the easiest scenario. If all your long-term money is in a tax-advantaged account like an IRA, Keogh, 401(k), 403 (b), private pension plan or annuity, you can stop sweating.

You’re safe from the taxman until you begin making withdrawals. So if all your long-term money is in a qualified retirement plan, you’re already home free.

But, if you’re like most investors, your personal situation is probably a little more complex. You likely have liquid assets both inside and outside of retirement accounts. In that case, you will need to tax manage your investment portfolio.

The first order of business is to place the right investments in the right accounts for maximum after-tax returns. You’ll need to put your most tax-inefficient holdings into your tax-deferred accounts and the remaining holdings in your taxable accounts.

For example, real estate investment trusts (REITs) are highly tax-inefficient. Most of your return will come in the form of dividends and these are taxable at your income tax rate, not the 15% rate for corporate dividends.

Another tax-inefficient asset is high-yield bonds. Here the majority of the return comes from interest income - and all of it is taxable. A junk bond fund will typically make capital gains distributions from time to time, as well. So you want to place these in your tax-deferred account, if possible.

Also highly tax-inefficient are inflation-protected securities (TIPS). The semi-annual interest payments on TIPS are taxable, the same as other Treasury securities. However, investors are also taxed on inflation adjustments to the principal, a situation that is commonly described as taxing “phantom income.” For these reasons, you should also hold your inflation-adjusted Treasuries in your tax-deferred account.

High-grade corporate bonds and ordinary Treasuries pay taxable income, too. They, too, should be held in your tax-deferred account.

On the other hand, individual stocks are highly tax-efficient. You control when you decide to take profits, so you can control your tax liability. And long-term capital gains are taxed at a maximum rate of 15%, regardless of your tax bracket. (Although Mr. Obama wants to change that.)

Stock index funds are fairly tax-efficient, with one exception: small-caps. If a small company is successful and keeps growing, it will reach the point where it is no longer a small-cap stock. At that point it will eventually be removed from the small-cap index. When a small-cap index fund sells a small-cap that has become a mid-cap, it will generate a realized capital gain. That gain, of course, will be distributed to shareholders.

So be careful where you place the assets you own.

Money managers and financial planners often talk about the importance of asset allocation. Tax-managing your portfolio is what I call your asset “location” strategy. It’s simply a matter of owning your least tax-efficient assets inside your retirement account and your most tax-efficient ones outside them.

Don’t think for a minute that this isn’t worth the trouble. Effective tax-management of your portfolio is critical - and can dramatically increase your real-world returns.

As investment legend John Templeton famously said, “There is only one investment objective: maximum total return after taxes.”

In short, taxes matter…a lot. Take the basic steps I’ve outlined here to tax-manage your portfolio and you’re assured of higher real-world, after-tax returns.

Source: How to Legally Stiff-Arm the IRS