Intelligent investors focus on controlling costs. Choosing low-expense funds and a low-commission broker is a great start, but for many investors, the largest investment cost of all is taxes. If you have a taxable investment account, Uncle Sam is eventually going to claim a share of your returns, but there are steps that you can take to minimize the damage. By understanding how taxes affect your investments and intelligently dividing funds between taxable and tax-sheltered accounts, you can maximize your after-tax returns and increase your chances of reaching your investment goals.
What Makes a Tax-Efficient Fund?
Mutual fund investors incur taxes when a fund distributes dividends, interest payments, or capital gains from trading activity. The most tax-efficient funds have limited distributions in relation to their overall returns, and the distributions that they do make receive favorable tax treatment (i.e., qualified dividends and long-term capital gains). Fund turnover isn’t a perfect gauge of tax efficiency, but it can give us a clue about the frequency of capital gains distributions. Since index funds only trade securities when companies enter or leave the target index, they are historically much more tax-efficient than comparable actively-managed mutual funds.
Of course, even index funds can vary widely in tax efficiency, depending upon the unique structural and regulatory characteristics of different asset classes. Here are a few examples:
- Some international funds are slightly more tax-efficient than comparable US funds because they are eligible for the foreign tax credit.
- Small cap and value index funds often have higher turnover (and lower tax efficiency) than broad-based “Total Market” index funds because companies in these indexes routinely outgrow their small cap or value classification, leave the index, and must be sold by the fund manager.
- Bond funds as a whole have less-than-perfect tax efficiency because their gains are taxed at ordinary income rates.
- REIT funds are historically tax-inefficient because they are required to distribute at least 90% of income to investors, most of which comes in the form of non-qualified dividends.
Tax efficiency can also be a function of the investment vehicle. Since ETFs were introduced in 1993, their proponents have regularly touted their tax efficiency, primarily because of the in-kind redemption mechanism that allows ETFs to unload low cost-basis shares. Despite these claims, I believe that the jury’s still out on the ETF vs. index fund tax efficiency debate, especially within the unique share-class structure that Vanguard employs. However, there’s no arguing that the robust ETF marketplace clearly makes life easier for those who practice tax loss harvesting.
Tax-Efficient Fund Placement
In order to maximize your after-tax returns, it’s helpful to view all of your investment accounts as one big portfolio. Then, rank your investments from most tax-efficient to least tax-efficient using the principles outlined above. In general, a tax efficiency hierarchy organized by asset class might look something like this:
Top Tier: municipal bonds, tax-managed funds, broad-based US and international index funds
2nd Tier: small cap and value funds
3rd Tier: TIPS and bonds
Bottom Tier: high-yield bonds, REITs, commodities
To develop a more specific hierarchy using your individual funds, try using Morningstar’s historical tax efficiency statistics. Just plug a ticker symbol into the “Quote” box on Morningstar.com and select the “Tax” tab. Keep in mind that historical tax efficiency may not persist in the future.
Once you’ve established your personal tax efficiency hierarchy, simply start from the top of the list and assign the most tax-efficient fund to your taxable account(s). Move down the list, repeating this process, until you have filled your taxable account(s). Investment restrictions, like limited fund choices in your 401(k) account, may force you to go through this exercise a few times before finding a workable combination of funds, but it will be worth the effort.
If you’re not careful, Uncle Sam can take more than his fair share of your investment returns. When you’ve exhausted all tax-deferred investment options, don’t be afraid of owning tax-inefficient investments. Instead, take a big picture view of your portfolio and re-arrange your investments to maximize your after-tax returns. By focusing not only on which funds to pick, but also where you place them, you’ll keep a larger portion of future returns and maximize your chances of investing success.
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