Skip to Content
The Short Answer

More Ways to Reduce Uncle Sam's Take

A hefty tax bill isn't necessarily one of life's inevitabilities.

Mentioned: , , , , , , , , ,

Well, it's that time of year again. With tax day looming, investors are coming to terms with the tax consequences of their investment decisions. The pain is likely widespread: According to fund industry data, roughly two thirds of mutual fund assets are kept in taxable accounts. And last year was a banner year for capital gains payouts, so last year could've been very costly from a tax perspective.

Ignoring the impact of taxes on decision-making is a huge mistake. In his speech "The Relentless Rules of Humble Arithmetic," Vanguard founder Jack Bogle notes that the average equity mutual fund loses about 2 percentage points of its average annual return to taxes.

Why are mutual funds such a potential tax headache? By law, mutual funds are required to pass all income and realized profits on investments along to shareholders through income and capital gains distributions. If you're investing through a taxable account, you'll have to pay taxes on those distributions. Short-term gains are taxed at the higher ordinary-income rate, as is income from taxable bonds, commodities, and real estate investment trusts. Meanwhile, long-term gains and stock dividends are generally taxed at the 15% rate. Thus, funds that trade a lot, and thus generate heavy short-term gains, generally aren't tax-efficient. The same is true for income-heavy offerings, such as bond or REIT funds.

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