How Tax-Efficient Is Your Mutual Fund?

What Taxes Are You Paying?
Fund investors are at a disadvantage when it comes to taxes. Stock investors only pay taxes on an investment if they have pocketed dividends or income or have sold the fund for a profit. Exchange-traded funds have also been quite tax-efficient over time. But investors in conventional mutual funds can get stuck with a tax bill on their mutual fund holdings, even if they've lost money since they've held the fund. Like all investors, fund investors have to pay taxes on dividends from stocks and interest from bonds, and they also have to pay taxes on all fund distributions, including capital gains, which occur when a fund manager sells an underlying holding for more than its purchase price. (Read my colleague Russ Kinnel's take on the injustice of the mutual fund tax code here.)

So, what's the best way to gauge how hard a fund will be hit by taxes? As I mentioned in my article a few weeks ago, high turnover can be a signal that a fund might not be tax-efficient. That's not the only thing to look at, though. Pull up a fund on Morningstar.com and click on the Tax tab on the navigation bar at the top of the page to get a glimpse of a fund's tax profile.

Tax-Adjusted Return
One of the quickest ways to understand a fund's tax implications is to compare its pretax return with its tax-adjusted return. The tax-adjusted return accounts for a fund's capital gains, dividends, and interest during the period, but it doesn't include tax consequences from selling the fund in the future. Note that Morningstar.com uses the highest federal tax rate when dealing with short-term capital gains and income (currently 35%) and the 15% rate for long-term capital gains. State and local taxes aren't included in the calculation because they vary across the country. The tax-adjusted return also factors in sales charges that you pay from buying the fund, so you can get a sense of how much money you're losing to fees and taxes when comparing it with the pretax return. Meanwhile, the category rank helps you see how a fund's tax-adjusted return stacks up against its peers. It works in the same way as the category rank for total returns: a ranking of 1 is most desirable and means that the fund's tax-adjusted return is at the top of the category, and 100 means it's at the bottom. It's worth noting that a fund can have a good tax-adjusted return not because it's been tax-efficient but simply because it has a high pretax return. However, you'll want to be careful about funds with big gaps between their pretax and tax-adjusted returns.

Morningstar.com provides tax-adjusted returns for the three-, five-, and 10-year periods. Although longer time periods are generally more meaningful when it comes to evaluating funds' performances and characteristics, in some cases it might be useful to look at the shorter time periods. For example, if there's been a recent manager or strategy change that's affected the fund's trading pattern, the three-year tax-adjusted returns may be more instructive than the five- and 10-year numbers.

Tax-Cost Ratio
Another useful metric is tax-cost ratio, which looks at how big of a bite taxes take out of a fund's annualized return. Unlike tax-adjusted return, sales charges aren't considered in the tax-cost ratio. Morningstar.com lists the average three-, five-, and 10-year tax-cost ratio for each fund. Think of tax-cost ratio as you would an expense ratio: The lower it is, the easier a fund is on the wallet if you own it in a taxable account. The average tax-cost ratio for equity funds tends to fall between 1 and 1.2. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. That's not to say that you should buy a fund just because its tax-cost ratio is low or zero, however. It could have plenty of other things wrong with it, like poor management, a bad record, or high fees. On the flip side, many good funds pay out distributions, so you shouldn't necessarily avoid a fund just because it has a tax-cost ratio. Just be careful to keep funds with high tax-cost ratios in nontaxable accounts such as 401(k)s and IRAs.

Potential Capital Gains Exposure
Whereas tax-adjusted returns and tax-cost ratios look at funds' tax efficiency in the past, a fund's potential capital gains exposure helps you gauge how big of a future tax bill you could possibly face. It measures how much a fund's underlying holdings have appreciated in value, adding up capital gains that haven't yet been distributed to the fund's shareholders and dividing that number by the fund's total net assets. A positive PCGE means some of the fund's investments have gone up in value and could cost shareholders come tax time if the manager sells any of those securities and distributes the gains to shareholders. A negative PCGE means the fund's underlying holdings have lost money, so taxes shouldn't be an immediate concern.

PCGE is especially important for investors looking to buy a new fund. If a fund has a high PCGE, investors can get stuck paying taxes on capital gains that occurred before they were even shareholders. On the other hand, funds with negative PCGEs may be tax-efficient because the losses can offset future gains. It's helpful to look at a fund's turnover alongside its PCGE. A fund with high turnover (generally more than 100%) could chew through its tax losses pretty quickly, lessening the tax benefit. That said, now is a good time to buy from a tax standpoint: Roughly 80% of all mutual funds currently have negative PCGE after last year's market downfall.