Taxes can be a big issue for investors: No one wants to make money on an investment only to have to give a major portion of it to Uncle Sam. So instead of asking politicians for a tax cut this year, investors may want give one to themselves by adopting some tax-efficient investment strategies.Tax-efficient investing is a key component to building wealth, says Norm Mindel, a certified financial planner and partner at Lombard, Ill.-based money-management firm Forum Financial. "There are three risks when you invest: market risk, inflation and tax risk," Mindel says. "So taxes are a factor in generating returns." Since some investment vehicles have higher tax consequences than others, it is important to understand the tax risks associated with each investment and the options available to defer or eliminate that risk.

Over his 25 years as a financial adviser, Mindel has emphasized a well-diversified investment strategy that is passively managed and tax efficient. The author of Wealth Management in the New Economy says there are four rules to remember when trying to apply tax-efficient investing -- rules that can also help you make better investment decisions.

1. Design a tax-efficient asset allocation plan.
After you've determined the proper asset allocation for your age and investment goals, make sure you have some tax efficient accounts. Most individuals will have an IRA or 401(k) account that allows deferral of taxes on investments until age 65.

Taxable bonds, real estate investment trusts, and global or international bonds are examples of investments that generate income, which may trigger high levels of taxes for investors. Mindel suggests placing these types of investments into the tax-deferred accounts.

"Doesn't it make sense that if you have something that generates a lot of taxable income, you would put them into the account where you don't have to pay taxes on it right away?" he asks.

2. Sell risky assets and pay the taxes, rather than lose everything trying to avoid them. Mindel tells the story of how he held a seminar for a group of investors in their 60s and 70s in 1998 during the Internet bubble, and they refused to sell their technology stocks because they didn't want to pay the taxes.

"They had 80% to 90% of their portfolios sitting in technology and we begged them to reallocate," he recalls. The tax to sell the securities was 20% at the time, and he asked, "Don't you think the stock could go down by more than 20%? Why not pay the 20% and buy some CDs?"

Many of them were wiped out when the Internet bubble burst in 2000. So don't go overboard trying to save on taxes, Mindel says, because if you let taxes be the No. 1 criterion dictating your investment moves, you'll never get a chance to reallocate and get rid of inappropriate assets.

3. Look for tax-efficient mutual funds. When buying mutual funds, investors should be aware of the turnover ratio because that will generally tell how tax efficient -- or inefficient -- they are.

"A mutual fund that turns over its holdings 100% to 120% each year is probably going to generate some taxes," says Mindel. He suggests investors lean toward index funds that normally turn over their portfolios 20% or less.

Passively managed funds generally have the lowest turnover ratios. They include index funds, exchange-traded funds and special tax-managed funds that harvest their losses and their gains to try to reduce the capital gains distributions. Vanguard offers several tax-managed funds, including Vanguard Tax-Managed Capital Appreciation (VMCAX), Vanguard Tax-Managed Growth & Income (VTGIX) and Vanguard Tax-Managed Balanced (VTMFX).

4. Rebalance even if you incur taxes. At some point, investors must rebalance their portfolios to take some of the profits from the best-performing investments and diversify the allocations so that risk is managed appropriately. Mindel says to start the rebalancing process in the tax deferred accounts -- IRAs or 401(k)s. Then move to the taxable accounts, looking to make as few trades as possible.

"If you find that you are forced to rebalance in your taxable accounts, we believe the costs of taxes are far outweighed by the benefits of rebalancing," he says.

Some experts advocate rebalancing once a year, others say to rebalance any time an asset becomes more than 10% to 20% out of balance with your asset allocation model. Whichever method you select, stick with it.

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