How to Use Tax-Efficient Funds to Your Advantage

Best Types of Mutual Funds and ETFs to Reduce Taxes

mutual funds pie chart

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If you don't know about tax-efficient funds, you may be paying more taxes than necessary and potentially reducing your long-term investment performance. The failure to apply the basic concepts of tax-efficient investing is among the biggest mistakes made by investors. Learn how to use tax-efficient funds so you can keep more of your hard-earned money.

What Are Tax-Efficient Funds?

Tax-efficient funds are mutual funds or exchange-traded funds (ETFs) that generate lower relative levels of dividends and capital gains compared to the average mutual fund. Conversely, a fund that is not tax-efficient generates dividends and capital gains at a higher relative rate than tax-efficient mutual funds or ETFs.

Tax-efficiency is a concern primarily for investors who have taxable accounts. This is because dividends and capital gains distributions produced by funds that aren't tax-efficient are liable to be taxed. When these taxable gains and dividends are produced from a taxable account, the investor must pay taxes on it during that tax year.

These same taxable gains and dividends would not be subject to taxes if they're held in a tax-deferred account, such as IRAs and 401(k)s.

Examples of Tax-Efficient Funds

Tax-efficient funds generate little or no dividends or capital gains distributions. Therefore, you will want to find mutual fund types that match this style if you want to minimize taxes in a regular, taxable brokerage account.

Here are examples of tax-efficient funds.

Growth stock funds: Growth stocks generally pay little or no dividends because growth companies will often reinvest their profits, rather than share them with shareholders in the form of dividends.

Small-cap stock funds: Similar to growth companies, small-cap companies typically reinvest their profits into their respective businesses, rather than paying out dividends to shareholders.

Index funds: Since index funds are passively-managed, they generate fewer capital gains (that are then passed along to shareholders in the form of capital gains distributions) compared to funds with a manager that actively trades stocks.

Municipal bond funds: An investor who wants to minimize taxes but also has an income objective can use municipal bond funds, which pay interest that is free of federal income taxes. Depending on state and local laws, certain municipal bonds might also be exempt from state and local taxes. For example, a New York City resident who owns New York City municipal bonds is earning income that is tax-exempt on all three levels of taxation.

Examples of Funds That Are Not Tax-Efficient

Here are examples of funds that are not tax-efficient.

Large company stocks: Funds investing in large companies, such as large-cap stock funds, typically produce higher relative dividends because large companies often pass some of their profits along to investors in the form of dividends. Exceptions to this general rule of thumb include large-cap growth stocks.

Actively-managed funds: You also need to be cautious of actively-managed mutual funds because they tend to have higher turnover than passively-managed funds. This means that the active manager tends buy and sell the holdings more frequently than the passive manager. Placing more trades increases the chance of producing capital gains distributions.

Bond funds: Most bond funds—other than municipal bond funds—pay income from interest received from the underlying bond holdings, so they are not generally tax-efficient.

How to Know If a Fund Is Tax-Efficient or Not

The most basic way to know if a fund is tax-efficient or not is by looking at the fund's stated objective. For example, a "growth" objective implies that the fund will hold stocks of companies that are growing, rather than focusing on stocks that pay dividends. A fund that has an objective of "income" is, by nature, attempting to generate income from dividends (stocks), interest (bonds), or both. Therefore, funds that have an income objective are not generally tax-efficient.

A more direct way to know if a fund is tax-efficient is to use an online research tool that provides basic tax-efficiency ratings or tax-adjusted returns. You will want to look for tax-adjusted returns that are close to the "pre-tax returns." This indicates that the investor's net return has not been eroded by taxes, thus helping to improve long-term performance.

Example of Tax-Efficient Investing Practices

Let's say an investor has two different investment accounts:

  • A 401(k), which is a tax-deferred account
  • A regular individual brokerage account, which is a taxable account

Assuming the investor was primarily seeking a long-term growth objective (they have a time horizon of 10 years or more and want to grow their investments), they will hold the least tax-efficient funds in their 401(k) and the most tax-efficient funds in their regular brokerage account.

With this strategy, the dividends, interest, and capital gains produced by the inefficient funds—bond, active, and income funds—in the 401(k) will not produce current taxes for the investor. The tax-efficient funds—small-cap stock, index, and growth funds—in the brokerage account will generate small amounts of current taxes (if any) for the investor.

The Bottom Line

Investors are wise to keep taxes to a minimum because taxes are a drag on the overall returns of the mutual fund portfolio. If the investor only has tax-deferred accounts, such as IRAs, 401(k)s, and annuities, there is no concern about tax-efficiency because there are no current taxes owed while holding the funds in one or all of these account types. However, if the investor uses taxable brokerage accounts, they may try to concentrate on holding only index funds and ETFs in those taxable accounts.

Therefore, the basic lesson here is to consider the type of account you're using as you choose investments to hold within it.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.