Mutual Funds: Tax-Efficient Funds

The good news is that mutual fund you invested in posted huge returns for the past year. The bad news is the ides of April are on the horizon.

Yes, when a fund distributes its capital gains, shareholders have to report those gains as taxable income. These taxes can add up to take quite a bite out of those gains, especially if that hot fund you invested in trades stocks like hot potatoes. If a fund only holds stocks for short periods, meaning it has a high turnover rate, that frequent selling can boost taxes.

But, let's have some more good news. The ever-accommodating fund world has created an offering that addresses these taxing matters: the tax-efficient fund. Tax-efficient funds implement strategies that aim to minimize your tax bill, such as keeping turnover levels low or shying away from companies that provide dividends, which are regular payouts in cash or stock that are taxable in the year that you receive them. These funds still shoot for solid returns, they just want less of them showing up on your tax returns.

Index funds, which tie their performance to a specific index such as the S&P 500, are generally considered tax-efficient as well, since they only execute trades when the makeup of the benchmark index changes. (For more information, please read the Getting Started entry on the Index Funds .)

Even if you aren't interested specifically in a tax-efficient fund, investors are well served by keeping an eye on a fund's taxes as part of the overall push to keep costs down. (For more on this subject, please read the Getting Started entry on Fund Expenses.)

Funds and the Tax Man

TheStreet.com often examines tax issues regarding mutual funds in the Mutual Funds stories in the Personal Finance section, as well as in the Tax Forum column. For starters, here are a few articles that provide some free tax advice regarding fund investing.

You Should Be Tax-Aware, Even If Your Fund Isn't

The Nitty Gritty on Fund Distributions

Capital Gains Can Be a Double Whammy for Fund Shareholders

Mutual Funds Can Be a Taxing Proposition for Foreigners