How to Use Tax-Efficient Funds to Your Advantage
Best Types of Mutual Funds and ETFs to Reduce Taxes
If you don't know about tax-efficient funds, you may be be paying more taxes than necessary and potentially reducing long-term performance. The failure to apply the basic concepts of tax-efficient investing is among the biggest mistakes made by investors. Learn how and where to 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/or capital gains compared to the average mutual fund. Conversely, a fund that is not tax-efficient generates dividends and/or capital gains at a higher relative rate than other mutual funds or ETFs.
Tax-efficiency is a concern primarily for investors who have taxable accounts. This because funds that are not tax-efficient generally produce dividends and/or capital gains distributions that are taxable to investors in accounts that are not tax-deferred. Such taxes are not owed when investing in tax-deferred accounts, such as IRAs, 401(k)s, and certain annuities.
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 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 less capital gains that are then passed along to shareholders in the form of capital gains distributions.
Municipal bond funds: An investor wanting to minimize taxes but also has an income objective can use municipal bond funds, which pay interest that is free of federal income taxes.
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. An exception is 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 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 tax-efficient 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, not paying dividends.
A fund that has an objective of "Income" is by nature attempting to generate income from dividends (stocks) or 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, such as Morningstar, that provides basic tax-efficiency ratings or tax-adjusted returns, expressed as their "tax-cost ratio." 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 away 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: 1) A 401(k), which is a tax-deferred account and 2) A regular individual brokerage account, which is taxable. 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.
The strategy is to hold mutual funds that are not tax-efficient in a tax-deferred account and to hold mutual funds that are tax-efficient in the taxable account. This way the dividends, interest and capital gains produced by the inefficient funds in the 401(k) will not produce current taxes for the investor and the tax-efficient funds in the brokerage account will generate small amounts or no taxes for the investor.
- In the 401(k), the investor can hold their bond funds, actively-managed funds, and/or mutual funds with stated "income" objectives.
- In the regular brokerage account, the investor can hold their small-cap stock funds, index funds, ETFs, and/or mutual funds with stated "growth" objectives.
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/or 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 has only taxable brokerage accounts, they may try to concentrate on holding only index funds and ETFs.
Therefore the basic lesson here is to place funds that generate taxes in a tax-deferred account so you get to keep more of your money growing. If you have accounts that are not tax-deferred, such as a regular individual brokerage account, you should generally try to invest in mutual funds or ETFs that are tax-efficient.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.