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Tax efficiency and mutual funds

Dear Money Matters,
Do I have to watch tax efficiency when selecting a mutual fund? How important is it? -- Bwestra

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Dear Bwestra,
Absolutely, tax efficiency is one of the elements you should examine when choosing a mutual fund. For those who may be unfamiliar with the term, tax efficiency refers to the amount of taxes that a fund pays out as part of its regular investment activities. That may seem like the fund's headache and not yours, but taxes are subtracted from the fund's return that's ultimately paid out to its investors. The higher the tax burden, the bigger the chunk of change pulled from your pocket.

The good news is that the Securities and Exchange Commission requires funds to disclose their tax efficiency. It's simple to track down, either through the fund's annual report, quarterly filings or any number of online mutual fund tracking sites or print publications. Many sites, newspapers and magazines illustrate how much taxes drain from a fund, either through calculating the after-tax return to investors or by showing how much of a given investment -- say $1,000 -- is lost over time to taxes. You can use those figures to compare funds.

An unduly heavy tax burden can gut even the best mutual fund performance. For instance, it's common to see a fund whose performance appears to be excellent, only to actually come out rather poorly after taxes are calculated. I recently saw one fund whose five-year annual rate of return topped 8 percent -- a seeming category leader. Unfortunately, it was also a leader in tax inefficiency, which pushed this apparent high flier toward the bottom of its peer group.

So it's essential to take those ads touting astronomic returns with a shaker or two of salt. Even the sweetest fund can turn sour if its tax efficiency is crippling. And that makes tax efficiency an essential element of any mutual fund research, along with portfolio mix, investment philosophy and management.

Bankrate.com's corrections policy-- Posted: April 16, 2002
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