Course 104: Mutual Funds and Taxes
Avoiding Overtaxation
In this course
1 Introduction
2 Funds, Capital Gains, and Income
3 Distributions and Taxes
4 Avoiding Overtaxation

Alleviate tax headaches by following these tips:

Tip One. Ask a fund company if a distribution is imminent before buying a fund, especially if you are investing late in the calendar year. (Funds often make capital-gains distributions in December.) Find out if the fund has tax-loss carryforwards, that is, if it has booked capital losses in previous years that can be used to offset capital gains in future years. That means the fund could be tax-friendly in the future.

Tip Two. Place tax-inefficient funds in tax-deferred accounts, such as IRAs or 401(k)s. If a fund has a turnover rate of 100% or more, it's a good indication that limiting the tax collector's cut isn't one of the manager's objectives.

Tip Three. Search for extremely low-turnover funds, in other words, funds in which the manager isn't doing a lot of buying and selling and therefore isn't realizing a lot of taxable capital gains. A fund with a turnover rate of 50% isn't four times more tax-efficient than a fund with a 200% turnover rate. But funds with turnover ratios below 10% tend to be tax-efficient. You can find turnover rates on Morningstar.com, as well as in your fund's annual report.

Tip Four. Favor funds run by managers who have their own wealth invested in their funds, such as Dodge & Cox Stock DODGX and American Funds Growth Fund of America AGTHX. These managers are likely to be tax conscious because at least some of the money they have invested in their funds is in taxable accounts.

Fund companies now have to report to the SEC annually how much managers have invested in their funds. Morningstar tracks and reports on this data in our mutual fund Stewardship Grades, available on Morningstar.com.

Tip Five. If you want to buy a bond fund and are in a higher tax bracket, consider municipal-bond funds. Income from these funds is usually tax-exempt.

Tip Six. Consider tax-managed funds. These funds use a series of strategies to limit their taxable distributions. Vanguard, Fidelity, and T. Rowe Price all offer tax-managed funds.

Even following these tips, it can be difficult to find a fund that's consistently tax-efficient. But don't get so caught up in tax considerations that you overlook good performance. After all, a tax-efficient fund that returns 7% after taxes is no match for a tax-inefficient fund that nets 15% after Uncle Sam takes his share. (You can find after-tax returns in our Fund Reports on Morningstar.com.) In the end, it is what you keep, not what you give away, that counts.

Next: The Quiz >>


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