Applying Salve to the Government’s Bite

Are you happy with your fund portfolio but worry about taxes? Mutual fund rankings rarely account for taxes because individual tax situations vary, which means the effective return on the same fund varies too.

Of course, tax efficiency doesn’t matter much in tax-deferred accounts such as IRAs and 401(k) plans. But in regular accounts, investors who are busy counting their profits often forget that what really counts is the amount of profit you earn after the government gets its share.

Such after-tax profits can vary greatly from a fund’s pretax returns, which are what is widely reported.

In fact, one study by two Stanford University professors found that, on average, investors get to keep only half their fund profits after taxes.

There is, however, something you can do to reduce the tax bite. The same study found that your tax bill will depend on the type of fund you pick.

For example, two funds that each gain 15% before taxes might have quite different after-tax returns if one of them is better than the other at minimizing shareholders’ taxes. Such differences explain why the funds with the highest pretax returns don’t always have the highest after-tax returns.

Typically, the worst tax bills are generated by funds that make lots of trades. Every time a fund sells a stock or other security for a profit, it must distribute the profit to shareholders--who must in turn pay taxes on that money.

For example, say the Fast Fund buys 10,000 shares of Microhard at $100 apiece, and sells them for $101 two days later. That creates a $10,000 gain ($1 for each share of Microhard). The $10,000 is distributed to shareholders (typically late in the year), and they pay taxes on it.

But what if the fund holds Microhard for another two years? The value of the fund shares may climb during that period to reflect any gains in the stock. But shareholders will pay no tax on that gain until the stock is sold.

Meanwhile, their profits in Microhard can continue to work for them, generating higher after-tax returns in the long and short run.

Tax efficiency also depends on other factors. For example, one study by Morningstar Inc. found that stock and bond funds with higher yields (a measure of current income) are less tax-efficient for some investors, especially those in higher tax brackets. That’s because many shareholders pay higher income taxes on dividends than on the capital gains that come from selling a security for a profit.

Similarly, funds that hold short-term bonds are more tax-efficient than those that hold long-term bonds. The reason is that long-term bonds pay higher yields and are subject to greater price swings that can generate capital gains.

Some funds try to keep taxes down by using losses to offset taxable gains. Others employ more sophisticated trading strategies with taxes in mind. But many simply don’t worry about it: They’d rather shoot for the big pretax returns that get them to the top of the performance rankings.

What should fund investors do?

Some might consider investing in “tax-managed” funds that make a point of maximizing after-tax returns. These include Vanguard’s Tax-Managed Fund ([800] 662-7447; $10,000 minimum investment; no-load), which offers three portfolios: Capital Appreciation holds the lowest-yielding stocks in the Russell 1,000 index, Growth and Income mimics the S&P; 500 index, and Balanced tracks the Russell 1,000.

At the least, be suspicious of a fund with a very high turnover rate (the percentage of the portfolio that changes every year); if it’s well above 100%, tax efficiency may suffer. Also beware of funds that change managers frequently. Often, a new manager’s first move is to sell everything and start over--creating huge tax bills for faithful shareholders.

Finally, remember that tax efficiency doesn’t matter in tax-deferred accounts such as IRAs and 401(k) plans. Thus, if you really like a fund that has high turnover and little regard for tax issues, consider buying it in your retirement account.