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When Bad Taxes Happen to Good Funds

Learning from past misfortunes can help investors avoid future tax woes.

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For mutual fund investors, taxes can be an unpleasant surprise, partly because they're largely out of the individual’s control. Mutual funds build up unrealized gains and are required to distribute those gains to shareholders on a pro-rata basis after they’re realized. As a result, shareholders can end up getting hit by unexpected tax bills, even if they didn’t benefit from previous appreciation.

For investors in taxable accounts, the impact can be significant. Over the past five years, Morningstar’s Tax Cost Ratio--a measure of the reduction in returns from taxes on fund distributions--has averaged about 1.8% for U.S. equity funds. Like fund expenses, taxes directly reduce an investor’s take-home pay--the amount of money you end up with after paying taxes and fees. But the return hit from taxes is nearly twice as large [1] as that from annual expenses, which average 0.98% for diversified U.S. equity funds.

Amy C. Arnott does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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