How Taxes Affect Your Returns

Last week I discussed why costs matter when investing. By considering taxes as an additional expense, you’ll be able to make informed decisions that, all else being equal, can help your portfolio’s returns over the long run.

Research by Vanguard’s Investment Counseling & Research group shows that taxes on dividends and capital gains can be a significant drag on a fund’s overall performance—in many cases, the largest single drag. And that’s particularly true for stock funds.

Investing in funds that generate high taxable distributions isn’t necessarily bad—if you hold those funds in tax-advantaged accounts such as IRAs or 401(k) plans, where you’re not subject to annual taxes on capital gains and dividend distributions.
Key factors to consider when evaluating a fund’s tax-efficiency:

* Index versus active. Broad-based index funds are generally more tax-efficient than actively managed funds. Index funds buy and sell stocks in small increments throughout the year, which can limit capital gain distributions. Active funds tend to buy and sell stocks in larger lots, creating larger taxable events.

* Pre- and post-tax returns. When researching a fund, pay attention to the “returns after taxes” shown in the fund’s profile. This will give you an idea of how much of a bite the government has taken in the past. The goal is not to minimize taxes, but to maximize after-tax returns.

* Dividend yields. The federal government reduced taxes on qualified dividends in 2003, but dividends in taxable accounts are still subject to taxes. Take a close look at how the dividend yields in your taxable funds measure up.

If you’re seeking greater tax-efficiency, tax-managed funds bear serious consideration.

“Tax-managed funds leverage the advantages of indexing, but seek to improve upon after-tax performance through low costs and lower tax realizations,” said Francis M. Kinniry, Jr., of Vanguard’s Investment Counseling & Research group. “To do this, these funds generally require higher minimum initial investments, adopt early redemption fees to discourage short-term trading, and employ ‘loss harvesting‘ strategies that limit the amount of capital gains that are realized.”

When comparing pre- and post-tax returns, bear in mind that small differences between funds don’t necessarily imply greater tax-efficiency. Because returns are calculated after costs are deducted from dividends, a small gap might simply indicate higher fund expenses.

For example, if a hypothetical fund has a dividend of 1.50% and its expense ratio is also 1.50%, you won’t owe taxes on the dividend, because there will be no dividend after costs. If, on the other hand, the fund has a lower expense ratio, you would receive a dividend, though you might have to give up a portion of it to the tax collector. The question is whether you’d rather give part of your dividend to the government—while keeping most of it yourself—or lose all of it to the mutual fund company. High fund costs may minimize your taxes, in other words, but they won’t help you keep more of your returns.

And that, of course, is the goal - to maximize your return. Low costs and tax effeciency do not guarantee greater returns, and therefore should not be your main focus. Your return should be. But, I believe that over the long run, low costs and tax efficiency certainly increase your odds of higher returns and you should give them due consideration when selecting a fund.