Dec. 25 reminds everyone of a jolly white-haired man who gives gifts to children.
On July 4 it's an austere bearded fellow who promotes patriotism.
Focusing on Needham Growth: An atypical investment strategy has produced an impressive record.
10 Questions With RS Global Natural Resources Fund Manager Andrew Pilara: Pilara analyzes the current energy situation, and explains why his top holding is a food company.
And on April 15 you might imagine a giant, boil-covered ogre who gobbles up your hard-earned money.
Yes, it's time to pay the tax man. And every year, investors must wonder how they can avoid losing so much to the IRS.
Of course, you should invest everything you can within a tax-deferred retirement vehicle, such as an IRA or a 401(k). But the next time you buy a mutual fund for your taxable account, try to find one that performs consistently well after taxes.
You'll have to do more than pick a fund that has the words "tax managed" in its name. You can, however, use the following guidelines to find one that can cut the IRS' take every year.
Tax-Efficiency Doesn't Tell You Everything
Mutual funds are required to pass along taxable bond interest, stock dividends and net realized capital gains to shareholders every year. This usually happens toward the end of the calendar year. But you'll be vividly reminded of a fat distribution when you sit down to do your taxes.
You'll owe taxes on these distributions, whether you sold the fund or not. Even if you don't take the cash and reinvest those distributions, you'll still pay taxes on them. (Generally, a distribution that's 15% of the fund's
net asset value or more is considered excessive.)
A fund's so-called tax efficiency will tell you the percentage of its return that it kept after taxes. Morningstar calculates this ratio on its
Web site in the Tax Analysis section. The highest possible score is 100%, which means the fund made no taxable distributions.
A high score here is important. But you'll also want to look at a fund's bottom-line, after-tax results.
"You cannot have a myopic focus on tax efficiency, because it's what you keep in the end that counts," says Bryan Olson, vice president in Charles Schwab's Center for Investment Research. "It's how much you kept after you pay your taxes."
A fund might have a tax efficiency score of 99%. But that figure doesn't mean much if the fund's after-tax returns were much lower than those on a similar fund. (Of course, you don't want to own a fund whose returns stink, period.)
When analyzing two comparable funds, compare their tax-adjusted returns, which you can also find on the Morningstar site. Those numbers will tell you which fund produced the better return after taxes. You can also find tax-adjusted performance figures in a mutual fund's prospectus. And one calculation included in the prospectus accounts for actual selling of the fund shares.
Signs of Selling
You should also think about what causes a fund to realize capital gains that might eventually get passed along to you. A fund realizes gains when it sells securities that have appreciated in value.
The hiring of a new fund manager often results in the selling of stocks the old manager owned, perhaps generating capital gains.
Sometimes shareholder redemptions could force a fund to unload stocks to raise cash. If tons of shareholders have been pulling their money out of a fund, you might want to avoid buying it, at least until the selling abates. The manager could be dumping stocks to meet redemptions, and thus, realizing gains. This happened to the
Oakmark fund back in 1999, when investors were fleeing the fund.
But the market's collapse over the past couple of years has made taxable distributions less likely. Managers are now looking at losses, which can help cut any capital gains distributions in future years. Specifically, losses can be used to offset any gains and reduce or eliminate any distributions to shareholders. And those losses can be carried forward for eight years. "We have talked to several managers recently who said, 'I am sitting on so many losses, I am not going to have to do anything to be tax efficient,' " says Schwab's Olson.
Indeed, mutual funds distributed just $72 billion in taxable capital gains last year, the lowest amount since 1995 and a vast improvement from the record $326 billion distributed in 2000.
Funds for the IRS-Averse
In your search for a tax-sensitive investment, you can start with large-cap index funds. Because these funds mimic broad market indices, they don't trade frequently, and that minimizes taxable distributions. Plus, they're cheap -- another bonus.
But some tax-managed funds do very well. "It's because so few funds focus on taxes," says Morningstar's Russ Kinnel. "It's almost free money for those who do."
To find out if a tax-managed fund is a good investment, you should compare its after-tax returns and expense ratio to similar funds. (And you always want to see an experienced manager and a solid track record.) If a fund is charging you a lot for its tax management, you should look elsewhere -- those charges might offset any savings produced by the tax efficiency.
One tax-managed fund that is worth a look: The
JP Morgan Tax Aware U.S. Equity fund. This fund's performance before taxes is solid. Its five-year annualized return of 10% beats 73% of other large-cap blend funds.
And only a tiny bit of that return has been taken by the tax collector. At the end of March, the fund's five-year annualized return was 10.3% before taxes. After taxes were taken out for distributions, it was 10.1%. Very little had to go to the IRS.
In keeping with TSC's editorial policy, Dagen McDowell doesn't own or short individual stocks, nor does she invest in hedge funds or other private investment partnerships. Dagen welcomes your questions and comments, and invites you to send them to