Here's an illustration of what I mean. Say one investor put $10,000 into Torray Fund
10 years ago, while another purchased Eaton Vance Large-Cap Value
. Assuming both investments are held in tax-free accounts, 10 years later, investors in either fund would have about $36,500. Not too shabby.
But the results would look dramatically different had the investors held the funds in taxable accounts. The investor in Torray would've earned $33,957 after taxes were taken into account, whereas the Eaton Vance fund investor’s aftertax return was more than $6,000 less--just $27,620.
Paying attention to the types of investments you select for your taxable accounts is arguably more important now than it has ever been. That's because many market prognosticators expect relatively modest returns from stocks and bonds over the next decade. With potentially less money coming in, it only makes sense to trim whatever investment costs you can, including the amount you'll owe to Uncle Sam.
Here are some of the key things to keep in mind when selecting investments for your taxable accounts.1. Go straight to the source.
Perhaps the most simple and effective way to improve your portfolio's aftertax return is to consider a fund that's explicitly designed to minimize the tax collector's cut. Investors in all mutual funds have to pay taxes on any income or capital gains their mutual funds pay out, regardless of whether those payments are reinvested in the fund. (For an overview of mutual funds and taxes, click here
.) So-called tax-managed funds try to keep those income and capital gains to a bare minimum. Although their strategies vary, most such offerings actively offset any capital gains with losses elsewhere in their portfolios and shun investments that generate ordinary income, which is taxed at the highest rate.
The result is that a tax-managed fund with returns that look unimpressive on a pretax basis may look superb--or at least quite healthy--on an aftertax basis. Vanguard runs a terrific suite of tax-managed funds for nearly every role in your portfolio (I enthused about the firm's no-nonsense Vanguard Tax-Managed Balanced Fund
in a recent column), while T. Rowe Price and Eaton Vance run solid tax-managed funds as well.2. Consider a municipal-bond fund.
Municipal-bond funds are the original tax-managed funds. Whereas any interest you earn from a conventional bond fund is taxed at your own income-tax rate, you won't have to pay federal income tax on a municipal-bond fund's payout; you may also be able to skirt state income tax by buying a muni fund dedicated to your state's bonds.
Although you might think municipal bonds are a tax dodge geared toward the super-rich, you needn't be in the highest tax bracket to benefit from opting for a muni fund. To help quickly determine whether you're better off in a taxable-bond fund or a municipal-bond offering, check out the Tax-Equivalent Yield function of the Morningstar Bond Calculator
. By plugging in the current yields of taxable- and municipal-bond funds you're considering, along with your own income-tax rate, you can quickly see how much the taxable-bond fund would have to yield to outstrip the muni fund's payout once taxes are taken into account.
There is, however, one notable caveat to bear in mind when venturing into municipal bonds. Although I noted that income from muni bonds generally isn't subject to federal income tax, the payouts of certain municipal bonds are subject to the Alternative Minimum Tax. To avoid muni funds holding AMT-subject bonds, look for those with "Tax-Free" or "Tax-Exempt" in their names. Such funds are required to keep 80% or more of their assets in bonds not subject to the AMT.3. Be picky about investment approach.
Maybe you have a hard time getting excited by the available tax-managed or municipal-bond funds. If you're venturing into funds that aren't explicitly geared toward keeping your tax bill down, you should know which fund types will tend to be tax-efficient and which will not.
When buying stock funds for your taxable account, you’ll generally want to focus on those that use low-turnover approaches--say, those with turnover rates of less than 25% a year, if possible. (A turnover rate of 25% indicates that a manager trades the entire portfolio every four years.) Higher-turnover funds tend to generate lots of capital gains, some of them short-term. Capital gains payouts are never welcome for taxable investors, but short-term gains are particularly harmful because they're taxed at your ordinary income-tax rate.
You'll also want to concentrate your search on those funds that generate returns via stock-price appreciation rather than income from bonds or other securities. That's because income from bonds and real estate investment trusts is taxed at the highest rate--your ordinary income-tax rate. (Stock dividends are less worrisome for taxable investors, because they're currently taxed at your capital gains rate.) If you're inclined to buy a heavy-income generator--such as a high-yield bond, real estate, or even a balanced fund--consider stashing it in a tax-advantaged account such as your IRA or 401(k) plan.4. Pay attention to history.
To help identify those funds that have historically done a good job of keeping the tax collector at bay or to see how tax-friendly your current holdings are, you'll want to pay close attention to the Tax Analysis section that we supply on each Morningstar Fund Report.
By eyeballing a fund's aftertax return and rankings, you'll be able to see how much of that offering's raw return an investor in the highest tax bracket would have been able to pocket once taxes were taken into account. For example, shareholders in Legg Mason Value
have taken home 15.92% of that fund's 17.16% pretax gain over the past 10 years, an aftertax return that places the fund in the top 1% of all large-blend funds. Contrast that fund with PIMCO StocksPlus
. On a pretax basis, shareholders in the fund have earned an 11.31% return over the past 10 years--good enough to land in the top 11% of the large-blend group. But investors in taxable accounts have only pocketed a 7% return over the past 10 years, dropping the fund’s aftertax return into the large-blend group's bottom half.
In the same section, Morningstar also provides a tax-cost ratio for each fund for each time period. My colleague Jeff Ptak provided a thorough discussion of what the tax-cost ratio is and how to use it in this article
. In short, you can use the tax-cost ratio much as you do a fund expense ratio, and you can add the tax-cost ratio to your fund's expense ratio to estimate that offering's total costs for investors in the highest tax bracket. For example, Legg Mason Value shareholders in the highest tax bracket paid 1.06% per year in taxes, on average, to own the fund over the past 10 years, and that's on top of the fund's 1.79% expense ratio. (And this, mind you, is a pretty tax-efficient fund.)5. Look to the future.
While tax-adjusted returns and tax-cost ratios will show you how tax-efficient a fund has been in the past, they won't tell you everything you need to know about whether a fund is likely to be a good bet for a taxable account in the years ahead. That's where Morningstar's potential capital gains exposure figure comes in. This statistic shows you what percentage of a fund's assets is made up of realized or unrealized gains or losses. For example, if a manager bought a stock at $10 five years ago and it's now selling for $110, the portfolio has $100 in unrealized appreciation per share. If he or she were to sell the stock tomorrow, shareholders would have to pay capital gains tax on that $100. Funds can also have negative potential capital gains exposure, meaning that the fund has losses on its books that it can use to offset future gains.
Of course, many funds have sizable potential capital gains exposure on their books precisely because
their managers have done a very good job of avoiding taxes in the past. Such funds may also figure to be good bets for a taxable account in the future, too. That's why it pays to look at a fund's past tax efficiency and its potential capital gain exposure in tandem. Morningstar.com Premium Members can put several of these statistics together to screen for funds that have been tax-efficient in the past and look to be good bets for taxable accounts in the future, as well. Click here
to see a screen that I ran to identify funds that figure to be a good bet for taxable accounts.6. Venture beyond mutual funds.
Although I've focused largely on mutual funds so far, your taxable account is a great place to hold individual stocks if you're inclined to do so, particularly if you trade infrequently. As I've noted, with a mutual fund you're on the hook for taxes on capital gains payouts regardless of whether you've sold any shares. If you own individual stocks, on the other hand, you don't have to pay capital gains tax until you yourself sell a share and lock in a gain.
Exchange-traded funds (ETFs) can also prove a tax-efficient alternative to mutual funds. ETFs sell on an exchange, meaning most trading takes place between shareholders. Individuals cannot redeem their shares for cash directly from the fund company. Thus, the fund manager doesn't have to meet redemptions, so he or she won't be forced to sell shares to raise cash, potentially realizing a capital gain. Furthermore, the large institutional shareholders that are permitted to redeem ETF shares directly from the fund company do not receive cash in exchange for their shares. Instead, when they redeem, they are given a basket of the stocks held in the ETF's portfolio. This allows the ETF to continually hand off its lowest-cost-basis shares to redeeming institutions, helping ETFs keep their potential capital gains exposure much lower than it would otherwise be. For a complete overview of the pros and cons of ETFs, click here
.7. Beware of generalizations.
Although ETFs are generally more tax-efficient than conventional mutual funds, there have been a handful of instances when ETFs have made sizable capital gains distributions. Along the same lines, index funds--mutual funds that track a given market benchmark--are also frequently cited as being more tax-efficient than actively managed funds, but that's not necessarily so, either. Index funds that track benchmarks that frequently make substantive changes to their holdings--notably, many small-cap index funds--may be no better for your taxable account than will actively managed funds.