Are Your Mutual Funds Tax Efficient?

Many investors haven’t heard of “tax efficiency,” but it’s a term you might want to be familiar with, because it could affect your total return.

A tax-efficient investment is one that can be reasonably expected to produce favorable tax consequences. For example, a 401(k) or variable annuity, whose taxes can be deferred, might be considered tax-efficient. A municipal bond fund, whose income is usually exempt from federal and state taxes, might also be considered tax-efficient (although municipal bond funds seek income that is federally tax free, a portion of the fund’s returns may be subject to federal, state, and local tax and the alternative minimum tax).

While these examples are fairly straightforward, the concept of tax efficiency becomes more difficult when applied to other types of mutual funds.

One element of a fund’s tax efficiency is its portfolio turnover rate, which is typically published in the fund’s annual and semiannual shareholder reports and/or prospectuses. Essentially, this figure represents how much trading activity occurred in a mutual fund’s portfolio over a year. It is generally considered by many to be a good indicator of a fund’s tax efficiency, because when portfolio managers buy and sell securities often, shareholders might pay more federal income taxes if these trades yield profit. Remember, even if you don’t sell your shares, you usually pay taxes on distributions paid to you by the mutual fund itself (even if reinvested).

On the other hand, a problem with the portfolio turnover rate is that it doesn’t reflect the type of selling activity. It doesn’t tell you whether securities were sold at a gain (which could result in a capital gains distribution) or a loss (which would result in no additional taxation, and could even be used to offset capital gains). It also doesn’t tell you whether capital gains were long-term or short-term in nature, which is important, because capital gains are taxed differently based on how long the security was held.

If you want to look at another measurement tool of a mutual fund’s tax efficiency, you can also look at its tax-efficiency ratio. This ratio is calculated by dividing a fund's tax adjusted return by its pre-tax return. The result is the percentage of total return that the average investor keeps after taxes — so the higher the ratio, the more tax-efficient the fund has been.

However, the difficulty is that not all mutual funds publish this ratio. I always advise people to consult with their own qualified legal, tax, and financial advisor prior to making any financial decisions.

If you would like to know more about the tax-efficiency of your fund investments, we can provide that information to you. Just call our office to schedule a complimentary meeting, either in person or by telephone. Please use the use the CONTACT US link and let me know.

I look forward to meeting you!