I REMEMBER speaking with an industry colleague about a company that had been in the news. He told me that he liked the company’s stock and, in fact, had bought it for the mutual fund he managed. Then he added, parenthetically, “I owned it, then I sold it, then I bought it back.”
This discussion highlights a fundamental challenge for investors: Mutual fund managers face incentives that often diverge from their clients. Specifically, fund managers are graded and compensated for their performance before taxes. But what really matters to fund shareholders is how an investment performs after taxes.
Why this mismatch? Why not evaluate fund managers on their true, after-tax returns? There is an explanation: Every individual fund shareholder faces his or her own unique tax treatment. A high-income individual might be in the top tax bracket, while a school or charity might pay no tax at all. Similarly, there are circumstances under which an individual might pay no tax. If you hold a fund in a tax-deferred account, such as a 401(k) or IRA, you aren’t taxed until you take the money out in retirement—and maybe not even then, if the money is in a Roth. In addition, some taxpayers might be in the 0% capital gains tax bracket or might have offsetting tax losses. In all of these situations, taxes wouldn’t be a factor, so fund companies have gotten in the habit of largely ignoring taxes.
But what if you do care about taxes? If you’re like most people, you receive a pile of tax forms each year and simply forward them to your accountant. But it’s worth taking the time to understand how your investments are impacting your tax return. According to research firm Morningstar, investors in actively managed stock funds give up approximately 0.75 percentage point of their return each year to taxes. In another study, Robert Arnott of Research Affiliates found that the tax impact can be as much as 2 percentage points or more, depending upon the time period.
While these may sound like small numbers, it’s important to view them in context. Historically, stocks have returned about 10% annually and bonds about 5%. If taxes are subtracting 1 percentage point per year, that means your actual take-home profits are being cut by 10% to 20%. This would be bad enough if it happened in any one year. But if it happens every year, it would have a serious impact on your wealth over time.
Are you investing through a regular taxable account, rather than a tax-deferred account, such as a 401(k), 403(b) or IRA? Here are some basic steps you can take to invest more tax-efficiently:
1. Look at a mutual fund’s prospectus. You can find this document on the fund company’s website. It may be dozens of pages, but just search for the words “Return Before Taxes.” There, you’ll see the fund’s performance over various time periods. On the next line, you’ll see “Return After Taxes on Distributions,” which shows what the fund’s after-tax return would have been for an individual in the top federal tax bracket. While that may not precisely describe you, the before- and after-tax figures can tell you a lot about how a fund is managed and how it might impact your tax bill in future years.
2. Check Morningstar’s Tax Cost Ratio, which the firm calculates for every fund and which gives you an idea of how much of a fund’s return was lost to taxes. To find this figure, go to Morningstar.com, enter the fund’s name at the top of the screen and then choose the “Tax” tab. If you compare a few funds, you’ll quickly begin to appreciate the differences.
3. Ask your tax advisor. Accountants are always happy to hear from clients outside of tax season. It would be a straightforward task for them to tell you the tax bill generated by your investments. You want to see that number in relation to the overall size of your portfolio. This is particularly crucial if you own non-publicly-traded investments, such as real estate, venture capital or hedge funds.
4. Stick with index funds. Because of their mandate—which is to buy and hold investments, with infrequent changes—most index funds generate low tax bills. That’s especially true compared to actively managed funds, whose managers might not think twice before buying, selling and then buying back the same investment—all in the same year.
Adam M. Grossman’s previous blogs include Protect Your Privacy, Free Lunch and Plan, Prioritize, Proceed. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.
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