Most wealthy Americans (those in the top two tax brackets) are not aware that taxes on their investments will get a bump in 2011, and again in 2013. The first one is due to the expiration of Bush tax cuts; the second is due to a 3.8% new “Medicare” tax on investment incomes.

The following table sums up the investment tax increases for the top-bracket taxpayers.

Note that the taxes on qualified dividends will increase from 15% to 43.3%, nearly a 200% hike! If you are in the top two tax brackets, what can you do to reduce the pain?

1. Invest more of your money in tax-exempt municipal bonds.
2. Put all of your equity investments in tax-aware mutual funds.

Let me expound on the second point. Most mutual funds operate as if Uncle Sam did not exist. The average mutual fund’s asset turnover is well over 100%, meaning that capital gains are realized at least once a year and subject to the higher short-term capital gain tax rate.

Tax-aware mutual funds, on the other hands, do a number of things to reduce taxes on investments:

1. They use security lending to convert dividends to long-term capital gains.
2. They use tax-loss harvesting to stretch realization of capital gains into the future.

Some funds have done these things marvelously, resulting in tremendous benefits to their investors. Instead of paying the higher dividend and short-term capital gain taxes every year, these investors end up paying long-term capital gain taxes effectively every 15 to 20 years. What difference would this make? Let’s see the following examples.

Mr. Knight is a top-bracket investor. He has $1mm invested in a regular mutual fund that has a before-tax return of 8% and an asset turnover of 100%. In 20 years,  Mr. Knight will make $1.32mm. Along the way, he will pay $1.01mm of taxes.

Mr. Day is also a top-bracket investor. He has $1mm invested in a tax-aware mutual fund that also has a before-tax return of 8% but an asset turnover of just 5%. In 20 years, he will make $2.53mm and he will only pay $789k in taxes.

As you can see, Mr. Day makes twice as much but pays a quarter less in taxes. Shall I say, the difference is Night and Day?

A free portfolio review (for those who have at least $500k investable assets)  can help determine if you are like Mr. Knight or Mr. Day.