Understanding Tax-adjusted Returns How Funds are Taxed The New Statistics Illustration Investment Implications

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As of February, the SEC is requiring mutual funds to report after-tax returns as well as the traditional pre-tax percentages when stating a fund's historical returns. The theory is that investors are better equipped in their decisions if they understand a mutual fund's performance after tax costs have been taken into account. But how significant is this information? And what, if anything, should we do differently?

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Everyone understands that selling a mutual fund can produce a short- or long-term capital gain, depending on whether the holding period has exceeded 12 months. But it's the annual taxation that is confusing. Funds that hold interest-bearing bonds or dividend-yielding stocks will pass through that income, often quarterly. These ordinary income distributions can be either paid in cash or, more commonly, are reinvested in additional shares of the fund. But these earnings are taxable annually, and the taxes are a drag on overall yield. The real wildcard is the capital gain distributions that also flow out of mutual funds. These occur when the fund has net gains from security sales. If the gains within the fund are short-term, they are taxed at ordinary income rates. The amount of these capital gain distributions can vary widely. Some funds rarely sell stocks, while others trade frequently. Hint: Take a look at the "turnover ratio" on a fund for a clue as to how actively the management of the fund trades securities. A 20% ratio, for example, would indicate that only 20% of the stocks on average are repositioned each year, while a 200% turnover ratio would indicate very active trading, with the content of the portfolio turning over twice within a year. High turnover ratios often lead to high short-term capital gain (ordinary income) taxable distributions.

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A mutual fund prospectus (but not its commercial advertising) must now disclose not only its pre-tax yields, but also two measures of after-tax performance. The first, labeled "return after taxes on distributions," discloses the impact of sales charges and, in addition, reflects taxes on both current income and capital gain distributions. The fund is required to assume that the taxes are incurred at the top ordinary income and capital gain rates. The second calculation, called "return after taxes on distributions and sale of fund shares," further reduces the yield by assuming that the fund shares have been sold and capital gain taxes paid at the end of the reporting period (i.e., sale occurred at end of one-year, five-year or ten-year disclosure period). While requiring the tax calculation to occur at the top rates is a conservative approach, recognize that there are no state income tax costs reflected in these after-tax figures.

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Here is a quick example to understand the impact that taxes and sales charges can have on funds. Assume that you are considering two different mutual funds, both with advertised 10-year pretax returns of 13.5%. But, digging deeper, you find that Fund A has an after-tax performance of 12%, while Fund B has a comparable 9% after-tax return (using the "return after taxes on distributions" figures). If you invest $10,000, and these same yields hold true for 10 years, an investment in Fund B would return about $23,700, whereas the more efficient Fund A would yield about $31,000 - over a $7,000 difference on a $10,000 investment held for 10 years! In judging these new after-tax returns, recognize that it is less important to view the absolute percentage, and perhaps wiser to compare the gap between the pre-tax and after-tax returns. The historical rate of return may not be much of an indicator of how the fund performs in the future. But the gap between the pre-tax and after-tax return can tell you much about the tax and sales charge efficiency of the fund. Thus, in the previous example, the problem with Fund B is the large gap between its 9% after-tax yield and the 13.5% pre-tax return, a "tax efficiency" ratio of only 67%. Translation: you keep only two-thirds of what you earn. Fund A, on the other hand, had an after-tax to pre-tax ratio of about 89%.

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To the extent you hold mutual funds inside 401(k) plans and other tax-deferred vehicles, such as variable life and variable annuity policies, these tax efficiency ratios are meaningless. You are incurring no current income taxes on any ordinary income or capital gain distributions of the mutual funds, although the sales charges and annual internal charges should still be of concern. In a well diversified portfolio, those mutual funds with less tax efficiency, such as bond funds and high distribution stock funds, should be held within retirement plans or other sheltered vehicles, if possible. And the portion of the portfolio that is owned directly should contain tax-efficient funds, particularly for higher income individuals. Most major mutual fund families offer several funds that are managed to be tax-efficient, declaring very low income or capital gain distributions. Also, index funds, a core part of many portfolios, tend to be very low in stock turnover and thus are more tax efficient. Using this new data can help investors to evaluate and position their mutual funds in a way that avoids those surprising year-end capital gain distributions that foul up your 1040!