Taxes--along with fees and expenses--can be one of the biggest drags on investment returns over time.
Let's look at the 10-year period ending Dec. 31, 2003. If you had invested in the "average" large-blend fund over that period, your initial investment would have compounded at an average annual rate of about 9.24% per year. But after accounting for taxes on distributions
(assuming distributions were taxed at the highest rates in effect each year), that number would have dropped to 7.36%--almost two full percentage points lower per year. That means that if you hold mutual funds in a taxable account, you're likely giving up a sizable percentage of your returns to the taxman.
On the bright side, tax efficiency is one of the factors you can usually control as an investor. Here are some ideas on maximizing your portfolio's tax efficiency.
Action Plan1) Pull up your portfolio, or if you haven't already, enter your holdings into Portfolio Manager. Here's the
link to create or import a portfolio--it takes only a minute.
2) To see how tax-efficient your funds have been, click on each fund's ticker to see its report on Morningstar.com. Click on the Tax Analysis link on the left side of the page. You can compare the fund's pretax return to its tax-adjusted return to see how big the damage has historically been. Fidelity Magellan Fund
, for example, has earned an average annual return of 8.88% for the trailing 10-year period ending Jan. 31, 2004. After taxes, that figure goes down to 7.18%, landing around the middle of the large-blend category. (Again, we're assuming investors paid taxes on distributions at the highest tax rates in effect when the distributions were made.)
3) To get another perspective on tax efficiency, look at the Tax Cost Ratio (also in the Tax Analysis section). This number represents the returns lost to taxes as a percentage of assets. It's similar to an expense ratio; in fact, you could add this number to the fund's expense ratio to get a more complete picture of the total cost of investing in a fund over time. A typical large-blend fund has a 10-year tax cost ratio of about 1.77%. If your fund has a higher-than-
average tax cost ratio, you might be better off in a different fund.
4) To get a handle on how tax-efficient your fund could be in the future, look at the Potential Capital Gains Exposure Percentage. (This figure is also in the Tax Analysis section of the report page.) The potential capital gains figure represents the percentage of fund assets made up of realized or unrealized gains on the underlying portfolio. It indicates what percentage of assets would be subject to taxes if the whole portfolio were liquidated. Thanks to the bear market from 2000 to 2002, some equity funds still have negative potential capital gains. But don't assume they'll never pay out taxable gains. Because this number is calculated as a percentage of assets, a fund's accumulated losses could be quickly wiped out if assets increase.
5) Don't forget to consider the tax impact of individual stock holdings. If you're considering making a trade in your stock portfolio, you can run the numbers in our
Trade Analyzer to see whether the trade makes sense given the transaction cost and the accumulated gain or loss on the position.
Learn MoreMorningstar offers a wealth of resources on tax planning and
maximizing tax efficiency. Here are some articles and other tools to
check out on Morningstar.com:
Taxes and Your Retirement Accountby Emily Hall
Tax Blunders to Avoid this Year
by Sue Stevens
Maximizing Your Tax-Deferred Investmentsby Emily Hall
Tax Strategies for 2004 and Beyond
by Sue Stevens
Is Your Fund Tax-Efficient?by Emily Hall
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