How to Use Tax-Efficient Funds to Your Advantage

Tax-Efficient Funds Definition, Examples and Strategies

mutual funds pie chart
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If you don't know about tax-efficient funds, you may be unnecessarily missing out on higher potential returns on your investments, especially in the long run.

Do you enjoy paying more taxes than necessary? Of course you don't! However investors do it all the time. Imagine the annual returns of your mutual fund portfolio are a paycheck. If you could find a way to keep more of your money by paying less taxes, would you do it? Of course you would! The failure to understand and apply the basic concepts of tax-efficient investing is among the biggest mistakes made by investors. Now is your time to learn how and where to to use tax-efficient funds so you can keep more of your hard-earned investment nest egg.

How Investors Make Taxable Mistakes

Mutual fund investors are often confused and surprised when they receive a 1099 form that says they had income from dividends or that they received capital gains distributions.

The basic mistake here is a simple oversight: Mutual fund investors often overlook how their funds are invested. For example, mutual funds that pay dividends (and hence generate taxable dividend income to the investor) are investing in companies that pay dividends. If the mutual fund investor is unaware of the underlying holdings of a mutual fund, they may be surprised by dividends or capital gains that are passed on to the investor by the mutual fund. In other words, the mutual fund can generate dividends and capital gains that are taxable without knowledge of the investor. That is, until the 1099-DIV comes in the mail.

Mutual fund investors also fail to plan which account to hold their funds based upon tax-efficiency - a concept and strategy called asset location (not to be confused with asset allocation). For example, investors do not owe current taxes from mutual fund dividends or capital gains in tax-deferred accounts, such as IRAs, 401(k)s and annuities. Typically, these dividends and/or capital gains are automatically reinvested in the fund and the fund continues to grow tax-deferred until withdrawals are made.

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 use mutual funds that are tax-efficient.

What Is Tax-Efficiency?

A mutual fund is said to be tax efficient if it is taxed at a lower rate relative to other mutual funds. Tax efficient funds will 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.

Examples of Tax-Efficient Funds

Tax-efficient funds generate little or no dividends or capital gains. Therefore, you will want to find mutual fund types that match this style if you want to minimize taxes in a regular brokerage account (and if your investment objective is growth - not income). First, you can eliminate the funds that are typically least efficient.

Mutual 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. Bond funds naturally produce income from interest received from the underlying bond holdings, so they are not tax-efficient either. You also need to be cautious of actively-managed mutual funds because they are trying to "beat the market" by buying and selling stocks or bonds. So they can generate excessive capital gains compared to passively-managed funds.

Therefore, the funds that are tax-efficient are generally ones that are growth-oriented, such as small-cap stock funds, and funds that are passively-managed, such as index funds and Exchange Traded Funds (ETFs).

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. These companies typically reinvest their profits back into the company - to grow it. If a company wants to grow, they won't pay dividends to investors - they'll reinvest their profits into the company. Therefore a mutual fund with a growth objective is more tax-efficient because the companies in which the fund invests are paying little or no dividends.

Also, index funds and ETFs are tax-efficient because the passive nature of the funds are such that there is little or no turnover (buying and selling of stocks) that can generate taxes for the investor.

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 specific fund type that pays high levels of income (not tax-efficient) is Real Estate Investment Trusts (REIT Funds), which are required by law to pass income on to investors.

A more direct and reliable 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" compared to other funds. 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.

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. 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.

Again, 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.

  • 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.

Alternative Tips and Examples of Tax-Efficient Investing

In summary, the ultimate objective for the wise investor is to keep taxes to a minimum because taxes are a drag on the overall returns of the mutual fund portfolio. However, there are a few alternative exceptions to this overall rule. 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.

If an investor needs current income, their concern for tax-efficiency is secondary to their need to generate income. Therefore this investor will naturally use funds that are less tax-efficient, such as bond funds and dividend mutual funds, to fulfill their income needs.

Another exception to general tax-efficiency rules exists with bond funds. For example, not all bond funds are "inefficient." An investor wanting to minimize taxes but also has an income objective can use municipal bond funds or tax-free money market funds, which pay interest that is free of federal income taxes.

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.