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Fund Spy

In Search of Tax Efficiency

Most mutual fund managers do not focus on aftertax performance, but astute investors may be able to improve their aftertax returns.

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Taxes are an important, but often overlooked, cost for investors who hold mutual funds in a taxable account. Most fund companies gauge their managers’ success on pretax performance and provide incentives accordingly. As a result, managers often ignore the potential tax implications of their actions. But taxable investors bear the cost.

Mutual funds are required to distribute all of their capital gains to investors each year. This means that investors are stuck with the tax liabilities of those gains even if managers reinvest them and investors don’t sell the fund. In contrast, investors don’t realize capital gains on individual stocks until they sell them. Although the same tax rate applies in both cases (assuming the holding period for both exceeds one year) and current tax distributions reduce investors’ future tax liabilities, deferring taxes allows the investment to compound at a higher aftertax rate.

Alex Bryan does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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