Mutual Funds That Reduce Your Taxes

This blog is part of a series by Dan Solin, author of The Smartest Money Book You’ll Ever Read. The book incorporates many useful money management tips from Mint.com, and can be purchased via the following retailers :  Amazon, Barnes & Noble, Nook and  iBooks.

It’s tax time and you may be in for some bad news. If you are an investor in mutual funds, you will likely owe taxes on your holdings and your tax hit could be substantial. Here’s why:

When the manager of a mutual fund buys or sells stocks (which is called “turnover”), those transactions result in either short-or long-term capital gains. Investors in shares of mutual funds have to recognize those gains and pay taxes on them, even when they have not sold their shares. The less frequently your mutual funds buy and sell, the lower the realized gains, and the less taxes you have to pay.

Of course, if you hold your mutual funds in a tax deferred account (like a 401[k] plan or an IRA), you don’t have to be concerned about tax consequences.

Tax Effects of High Turnover

Some fund managers of actively managed funds appear to ignore the tax effects of high turnover.  In 2010, the Schwab S&P 500 Index Fund (SWPPX) had a very low turnover. At the other extreme, the Prasad Growth Fund (PRGRX) had an unbelievable turnover of 598%!

On average, actively managed funds have a turnover of 85% of their holdings, every year. Not only does this high turnover increase your tax liability, it also runs up transaction costs, which further reduces returns by an average of 0.7% a year.

Most investors are unaware of the taxes they incur by investing in actively managed funds. You don’t feel the tax bite until the following April 15th, when you have to pay your taxes.

Prior to that time, although a tax liability is growing, few investors realize the day of tax reckoning is coming. By some estimates, more than 17% of pre-tax returns are lost to taxes.

Best Foot Forward

Mutual funds typically report returns on a before-tax basis. The reason is simple: aactively managed funds (where the fund manager attempts to beat a designated index) buy and sell far more frequently than index funds. Index funds buy or sell only when necessary to track the index.

Actively managed funds want you to invest in their funds, so they put their best foot forward, which is their pre-tax returns. If you knew their after-tax returns, and could compare them to after-tax returns of comparable index funds, you would be unlikely to invest in actively managed funds.

The difference in pre-tax and after-tax returns can be dramatic. Vanguard founder John Bogle compared the after-tax returns of active and index funds from 1980 through 2005 in his excellent book, The Little Book of Common Sense Investing. He found that $10,000 invested in the average actively managed fund grew to $108,000 before taxes. But when taxes were taken into account, the net to investors shrunk to $71,700.

The same investment in an S&P 500 index fund returned $181,800 before taxes and $159,000 after taxes. The active investor incurred a 33% tax hit.  The index investor paid a little under 13% in taxes.

Another study looked at 147 funds from 1963 to 1992. The authors found investors paid more than $1 billion in extra taxes over what they would have had to pay in a tax-efficient fund (like an index fund). They also found that using after-tax performance data, instead of pre-tax data, caused a dramatic change in fund performance.

You Get What You Don’t Pay For

The tax hit can convert funds that appear to be “winners” into losers. An analysis of the annualized returns of the top fifteen funds with the highest net assets for the five year period from 2003 to 2008 demonstrated that a simple S&P 500 index fund outperformed a number of funds that had superior pre-tax performance.

Taxes are important, but they aren’t the only reason you should limit your mutual fund purchases to low management fee index funds. Index funds have lower expense ratios (the management fees charged by mutual funds) than actively managed funds. Many studies have demonstrated that actively managed funds generally carry more risk and lower returns that globally diversified, risk-calibrated portfolios of index funds.

The reality is, when you consider both pre- and post tax returns, you are likely to be better off with index funds than actively managed funds. As John Bogle famously said, “Investors have learned, and learned the hard way, that in mutual funds it’s not that ‘you get what you pay for.’ It’s that, almost tautologically, ‘you get what you don’t pay for.’”

Dan Solin is a Senior Vice-President of Index Funds Advisors (ifa.com).  He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own.  His new book, The Smartest Money Book You’ll Ever Read, will be released January 3, 2012. You can buy the book at several retailers and in various formats, including: Amazon, Barnes & Noble, Nook and  iBooks.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.