What it means
When a fund sells investments at a profit, it often has to pass the gain on to its investors, who then owe tax on it even if they did not sell any shares themselves. A tax-efficient fund tries to limit these taxable events.
These payments can arrive even in years when the fund's price has fallen. The easiest way to do this is low turnover.
Index funds hold a stable basket of investments and rarely trade, so they realise fewer gains than funds with frequent trading. Lower turnover also means lower trading costs, which helps returns.
Some funds go further and are managed with tax in mind. They sell loss-making holdings to offset gains, choose which lots to sell to reduce the gain, and favour investments that produce less taxable income.
These funds usually describe their approach in the prospectus. Exchange traded funds can also be tax-efficient in some systems because of the way shares are created and redeemed.
This process can allow them to remove low-cost holdings without triggering a gain, though the details depend on local rules. An investor should not assume that every fund of this type gives the same result.
Efficiency matters most in taxable accounts. Inside a retirement or other tax-advantaged account, a fund's tax profile matters much less because the account shelters the distributions.
The best place for a tax-efficient fund is therefore a regular taxable account. The nuance is that tax efficiency is only one factor.
A fund with strong pre-tax performance and moderate tax cost can beat a tax-efficient fund with weak returns, so look at the after-tax result and the fees. Fees and the quality of the underlying investments should always be part of the comparison.
In practice
Real-world examples.
Example
An investor with a large taxable account compares an actively traded fund with a broad index fund. The index fund distributes little in capital gains, so she owes less tax each year. She switches and notes the cost basis of the new holding. She also reviews the fund's published tax cost ratio.
Example
A family trust looking for long-term growth chooses a tax-managed fund that sells losers to offset gains. The trustees review the fund's after-tax return each year. They find it comfortably beats the taxable alternative. They compare the figures with a conventional fund of the same type.
Example
A professional puts his income-producing bond fund inside his retirement account and holds an index equity fund in his taxable account. The arrangement keeps the heavily taxed income away from the tax bill. This is known as asset location. He reviews the placement whenever he adds new money.
Formula
Calculation
Tax cost = Pre-tax return - After-tax return
Suppose Fund A earns 8% before tax and 7.4% after tax, while Fund B also earns 8% before tax but only 6.6% after tax. Tax cost of Fund A = 8.0 - 7.4 = 0.6 percentage points, and Fund B = 8.0 - 6.6 = 1.4 percentage points. On $100,000, Fund A costs 100,000 x 0.006 = $600 in tax and Fund B costs 100,000 x 0.014 = $1,400, a difference of $800 a year.Case study
Seen in the real world.
Redwood Wealth is an illustrative, fictional adviser that reviewed a client's $500,000 taxable portfolio. The client held three actively managed funds with turnover above 90% a year, and the statements showed large capital gain distributions each December. The client had never realised how much of the return was lost to tax.
The adviser estimated that the funds cost the client about 1.3 percentage points a year in tax, or $6,500. A comparable set of index funds was estimated to cost about 0.4 percentage points, or $2,000. The difference compounded over time would be large.
In this illustrative story, the client moved to the lower-turnover funds, taking care to sell the old funds in stages to spread the gains over two tax years. The adviser projected annual tax savings of about $4,500 and reviewed the figures with the client every year.
Watch out
Common mistakes.
- Choosing a fund on tax efficiency alone, when returns, fees and risk still matter.
- Selling an old fund all at once to switch, which can trigger a large tax bill in one year.
- Holding a tax-efficient fund inside a retirement account, where its extra efficiency has little value.
Questions
People also ask.
How can I tell if a fund is tax-efficient?
Look at its turnover, its history of capital gain distributions and its published after-tax returns.
Are all index funds tax-efficient?
Most are more efficient than active funds, but they still pay dividends that are taxed, and some index strategies trade more than others.
Does tax efficiency matter in a tax-advantaged account?
Much less, because gains and income inside those accounts are not taxed each year.
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