When it comes to mutual fund investing, it's not what you earn that matters as much as what you manage to keep.
Indeed, the net return on your portfolio can be hugely impacted by how much you surrender each year to Uncle Sam.
Consider hypothetical taxable investments of $10,000 into two mutual funds that both have pretax total returns of 10 percent per year. One fund, however, has an after-tax return of 9 percent, and the other has 7 percent.
After 30 years, the investment with the smaller tax liability grows to almost $132,677 after taxes -- roughly 75 percent more than the $76,123 produced by the more heavily taxed fund.
Despite the clear advantage of tax efficiency, however, the significance is often lost on individual investors, as it is for many managers of actively traded equity funds whose only focus is pretax returns.
For those who own securities exclusively in tax-sheltered accounts, such as individual retirement accounts and 401(k)s, the need to manage tax liability is minimal. But those with both taxable and tax-deferred investments should take the threat of tax drag on performance seriously -- especially those in the upper income brackets, says Mark Luscombe, principal analyst for tax accounting group CCH in Riverwoods, Ill.
"(Managing tax liability) becomes more significant the higher your tax rates are and especially for those subject to the new, higher tax rates in 2013," says Luscombe. "There are new incentives to do something about it."
Effective this year, couples earning more than $250,000 may be hit by a new 3.8 percent Medicare surtax on net investment income, while joint filers with taxable income greater than $450,000 will face a 39.6 percent top marginal income tax rate, plus a bump to 20 percent from 15 percent on qualified dividends and long-term capital gains.
Your tax liability
Mutual funds that are not held in a tax-advantaged account produce taxable distributions each year in the form of dividend income, interest generated from bond funds and capital gains, created when securities held within the fund are sold.
As an investor, you will also owe capital gains when you sell shares of the fund at a profit.
Proceeds from investments held for one year or less are considered short-term capital gains and are taxed more heavily at your ordinary income rate, while securities held longer than one year are considered long-term gains and taxed at 20 percent for those in the highest 39.6 percent tax bracket.
Those in the 25 percent through 35 percent brackets pay 15 percent tax, and those in the lowest two brackets -- 10 percent and 15 percent -- pay zero.
Asset location vs. allocation
While asset allocation -- the process of determining the right mix of stocks, bonds and cash -- is your first order of business in portfolio planning, where you park those securities within your portfolio can make a big difference in your tax liability and long-term returns, says Maria Bruno, a senior investment analyst for The Vanguard Group.
"Asset allocation is the primary driver, but asset location becomes significant as you implement that allocation," she says. "It's very important when you have different accounts to know what types of assets to allocate where."
Generally speaking, your most tax-efficient funds are best reserved for your taxable brokerage accounts, says Bruno. Those include investments that do not produce a high yield, such as total market index funds, municipal bonds and tax-managed funds.
Conversely, actively managed funds, which may distribute capital gains in addition to dividends, and narrowly focused index funds belong in tax-deferred accounts such as an IRA, 401(k) or variable annuity. So, too, do taxable bond funds, which include high-yield bond funds, Treasuries and Treasury inflation-protected securities, or TIPS, since dividends are taxed as ordinary income.
The Roth advantage
Christine Fahlund, a senior financial planner and vice president with T. Rowe Price, notes that placing investments in a Roth IRA is another effective way to lower your future tax bill -- especially for younger investors.
Contributions to a Roth IRA are not tax-deductible since they are funded with after-tax dollars, but the earnings grow tax-free. With a traditional IRA, pretax contributions are deductible and benefit from compounded growth, but distributions upon retirement are taxed as ordinary income.