Avoiding the Tax Man

Now that tax season is over, are you kicking yourself for not having paid enough attention to the taxes that ate into your mutual fund returns? For instance, the average large-cap U.S. stock fund’s pre-tax return was 12.8%, according to Morningstar, a Chicago-based investment research firm. But when you consider that the tax-adjusted return was 9.8%, you can see why you might want to pay attention to tax efficiency. Don’t worry, there are steps you can take to get tax savvy for next year.

Though tax efficiency shouldn’t be your guiding investment principle, you should gauge your potential exposure to distributions from your funds. When mutual fund managers realize capital gains–profits from the sale of stocks or bonds–or their fund receives dividends or interest payments, any amount not used to cover expenses must be distributed to the fund’s shareholders. The shareholders are then taxed on those distributions. (Fortunately, distributions aren’t a concern when investors select funds for a 401(k) or IRA, which both allow investors to defer taxes until the funds are withdrawn.)

Tax-efficient funds aim to minimize the distributions that are made to shareholders, thereby limiting the amount of income that must be declared. A good first step to determine tax efficiency is to compare a fund’s pre-tax return and tax-adjusted return. “The bigger the gap between the pre-tax and the after-tax return, the less tax efficient the fund is,” says Catherine Gordon of The Vanguard Group Inc. in Malvern, Pennsylvania.

It’s also important to review a fund’s prospectus to determine its capital gains distribution history as well as its turnover rate–a measure of how often the manager sells stocks–which can trigger capital gains. Generally, the lower the turnover rate, the more tax-efficient the fund is.

Morningstar also provides a fund’s tax–cost ratio. By comparing a fund’s pre-tax return (adjusting for any sales charge), to its tax-adjusted return, the tax–cost ratio reveals what percentage of a fund’s returns are eaten up by taxes.

If you’re concerned about tax efficiency, consider index funds, which are more tax- efficient than actively managed funds. Another alternative is tax-managed funds. Vanguard, Fidelity, and other fund companies offer suites of tax-managed funds with returns that compare well to traditional mutual funds. But keep in mind that a high-performing fund, even factoring in taxes, may still outperform a “tax-efficient” fund with lower returns.

Tax-efficient FUNDS