Maximizing returns is about more than just selecting the right assets. It also involves optimizing tax benefits. Tax-efficient mutual funds are a key tool for achieving this balance.
Tax ramifications of mutual funds
Few mutual fund investors understand that they may have to pay taxes on the mutual fund’s capital gains, even if the mutual fund has a negative return and the investor hasn’t sold any shares. The law requires mutual funds to distribute any net capital gains on the sale of portfolio securities to shareholders.
Exchange-traded funds (ETFs) are typically more tax efficient than mutual funds because ETF shares are frequently redeemed in-kind, meaning an ETF may deliver specified portfolio securities to designated “Authorized Participants” instead of selling portfolio securities to meet redemption demands.
SEC rules require mutual funds and ETFs to disclose their after-tax returns in prospectuses.
If you purchase mutual funds in a non-retirement account, you should always compare returns after tax of the mutual funds you are considering.
Tax-efficient mutual funds
Tax-efficient mutual funds are engineered to minimize tax liabilities. They achieve tax savings primarily by purchasing tax-free or low-taxed investments, keeping turnover low, and avoiding assets that generate income, like dividend-paying stocks.
Index funds, which track specific market indices, have lower turnover rates primarily because the index they track, like the S&P 500, don’t frequently change their composition. As a result, the funds buy or sell assets less often, leading to fewer taxable events.
While many investors buy index funds and ETFs because of their low costs and diversification benefits, tax efficiency is another compelling benefit.
Why tax efficiency matters
The tax efficiency of mutual funds matters for these reasons:
Increase returns: Mutual funds generate income from dividends, interest, and capital gains. If a fund is tax-efficient, it’s structured to minimize tax liability, which can help you keep more of your investment returns.
Lower tax drag: Tax drag refers to reduced investment returns due to taxes. High tax drag can erode the overall performance of a mutual fund, especially over time. Tax-efficient funds minimize this drag by employing strategies like tax-loss harvesting, investing in tax-efficient securities, and managing distributions.
Long-term compounding: Over time, the impact of taxes on investment returns can compound, significantly affecting the final value. By choosing tax-efficient mutual funds, you benefit from compounding on a larger base, potentially leading to more significant wealth accumulation.
Better risk-adjusted returns: Tax-efficient mutual funds often have lower turnover, meaning they buy and sell securities less frequently. Lower turnover can result in lower transaction costs and reduce the impact of market volatility on the fund’s performance. This may lead to better risk-adjusted returns.
Better performance: One study found that tax-efficient funds outperformed other funds before and after-tax returns.
Selecting tax-efficient investments
Here’s how to select tax-efficient mutual funds
Research fund types: Look for funds specifically designed to be tax-efficient, like index funds or ETFs.
Assess fund turnover: Turnover refers to how frequently the fund buys and sells securities. Higher turnover can result in more capital gains distributions, which are taxable. Look for funds with low turnover to minimize tax liabilities.
Consider tax-managed funds: Tax-managed funds are actively managed funds that aim to minimize taxable distributions. These funds employ strategies like tax-loss harvesting and strategic asset location to reduce tax burdens.
Check expense ratios: High expense ratios can affect your returns over time. Look for funds with low expense ratios to maximize your after-tax returns.
Examine historical distributions: Review a fund’s past capital gains distributions to understand its tax efficiency. Funds with a history of large distributions may be less tax-efficient.
Evaluate fund structure: Certain fund structures, like mutual funds, are more prone to generating taxable events compared to others like ETFs. As discussed, ETFs often have an in-kind creation/redemption process that can help minimize capital gains taxes.
Consider location of assets: Different investment goals may require different types of funds. For example, suppose you’re investing for retirement in a tax-advantaged account like an IRA or 401(k). In that case, tax efficiency may be less of an immediate concern.
Historical performance: Examine the tax-cost ratio; a lower number indicates greater tax efficiency.
Consistency: Ensure the fund has maintained its tax efficiency across multiple years.
Investing wisely isn’t solely about choosing high-return assets but also about understanding and maximizing tax advantages. Tax-efficient funds should be a key component of your overall investment strategy. By embracing funds that strategically control capital gains distributions and offer consistent performance, you safeguard your returns from tax drag and maximize the possibility of more wealth accumulation over time.