Investing in Tax-Efficient Funds

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from Tax Planning for High Income Individuals, 5th Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ((800) 323–8724; ppc.thomson.com).

A mutual fund’s “tax efficiency” refers to how the fund’s operations affect when income will be distributed and taxable to shareholders. Tax efficiency can affect the overall net return a shareholder realizes from a mutual fund and is often one of the factors investors consider when selecting such investments. Tax efficiency is more likely to be a factor in funds holding stocks and other equity instruments, not when selecting mutual fund investments in retirement accounts like Sec. 401(k) plans and IRAs (and other tax-deferred accounts, such as variable annuities).

Definition

Tax efficiency is essentially a function of a fund’s portfolio turnover rate. “Turnover rate” is how often a fund sells (turns over) its portfolio. Generally, funds with high turnover rates are less efficient than those with low turnover rates; the disposal of securities causes the fund to recognize gain on appreciation. Because mutual funds must distribute virtually all of their income to shareholders each year, the more income a fund recognizes in a year, the more income shareholders must report.

Generally, the more tax efficient a fund is, the less current income a shareholder recognizes. In addition, many of the gains recognized by funds with high turnover rates are likely to be short-term rather than long-term and, thus, not eligible for the preferential capital gains rate.

Index Funds

Index funds tend to be more tax efficient than other mutual funds. Stocks held by an index fund normally replicate a particular securities market benchmark (e.g., the S&P 500 stock portfolio). Thus, the fund is not actively managed like funds with specific fund objectives. Index funds generally use a buy-and-hold approach to investing—selling securities only when cash is needed to redeem shares. They hold, rather than sell, appreciated securities; as a result, gains are generally unrealized. Index funds generally have a low turnover rate, which minimizes the current taxable income distributed to shareholders.

In addition to a lower portfolio turnover rate, index funds typically have lower management fees than do actively managed funds. Over a long investment period, the combination of lower turn-over and fees can significantly enhance an index fund’s overall return when compared to an actively managed fund.

Retirement Assets

As was mentioned, a fund’s tax efficiency is not an issue when selecting mutual funds for retirement account assets. This is an important consideration when choosing investments for taxable versus retirement accounts. An individual seeking to invest in both actively managed and index funds will generally benefit by using index funds for taxable investment assets and reserving actively managed funds for retirement assets.

Tax-Managed Funds

Some equity mutual funds are “tax-managed” funds, which seek to minimize taxes to shareholders by maintaining a low portfolio turnover rate and considering taxes when buying and selling securities. They often charge a redemption fee to investors who withdraw funds before a specified period (e.g., one year). Tax advisers with clients who want to minimize taxes through mutual fund investments might recommend such funds.

Other Considerations

When choosing mutual fund investments, investors must consider the fund’s tax efficiency in view of their particular tax situation. Many investors will want to minimize their current taxes and defer gain recognition to future years. This makes the more tax-efficient funds the most appealing. However, investors with capital loss carryovers, excess investment interest or other unused deductions may benefit from a fund with a high turnover rate more likely to generate higher current taxable income.

Of course, tax efficiency is only one factor in selecting a fund. The fund’s overall expected performance and whether it meets the investor’s personal financial planning needs are likely to be more important.

Example

John Henderson has $40,000 to invest in a stock mutual fund. After analyzing the various funds that meet his objectives, he has narrowed the choice to either the ABC Growth Fund or the ABC Index Fund. The former is an actively managed fund with a 150% annual portfolio turnover rate. The latter is a passive fund that replicates the performance of the S&P 500; it has a very low portfolio turnover rate. John is in the highest ordinary income tax bracket and plans to invest in the fund for the long term.

If John would be satisfied with either fund, he should choose the ABC Index Fund. Because it has a low portfolio turnover rate, much of the income he hopes to realize from the investment will be deferred until future years, when he redeems his shares. The fund’s annual shareholder distributions should be less than those of the ABC Growth Fund, which actually enhances the Index Fund’s return over the entire time John plans to hold it.

However, one of the disadvantages of investing in mutual funds is that, unlike holding individual securities, shareholders do not have total control over when unrealized gains will be recognized for tax purposes. In this regard, index funds and tax-managed funds typically provide shareholders with more control than do actively managed funds, because they have a lower annual portfolio turnover rate. Index funds and tax-managed funds may also be a good alternative to annuities or other retirement-oriented investments.