Reducing tax liability of mutual funds

"If someone is really concerned about paying taxes, they might consider a portfolio of only index funds, but we prefer the 'core and explore' method," says Justin Sinnott, a Seattle-based financial adviser for Charles Schwab & Co.

The investment strategy of core and explore consists of using index funds for efficient markets and actively managed funds for inefficient markets.

Growth-oriented small-cap and international mutual funds are two examples of inefficient markets, says Sinnott, since financial data are less readily available on the companies they invest in. Thus, managerial expertise is required to outperform.

Large-cap funds, by contrast, are more liquid and more transparent, requiring less hands-on maintenance. As such, notes Sinnott, they are generally best suited for the index fund portion of an investor's portfolio.

Tax-managed mutual funds are another option.

Managers in such funds keep their tax drag low by reducing turnover, purchasing tax-free or low-tax securities, avoiding dividend-paying stocks, and using losses to offset capital gains (a practice known as harvesting losses).

All that maneuvering, however, doesn't come cheap.

Michael Rawson, a fund analyst for Morningstar, notes tax-efficient funds tend to be pricier than similar funds from the same provider.

"It really needs to be worth your while to pay for that service," says Rawson, adding that such funds are best suited to taxable accounts for those concerned about taxes.

From a tax-efficiency standpoint, index exchange-traded funds are also often described as a better bet than their mutual fund counterparts, partly because they keep turnover low, but also because they produce fewer capital gains using a mechanism known as "in-kind redemptions."

Indeed, many ETFs require authorized participants to exchange shares for a basket of securities rather than cash, allowing the fund to raise cash without having to sell securities.

Here again, however, Rawson warns that not all ETFs are more tax-efficient than mutual funds.

"Tax efficiency is based upon good portfolio management, not the structure of the fund," he says.

“If someone is really concerned about paying taxes, they might consider a portfolio of only index funds, but we prefer the 'core and explore' method.”

Justin Sinnott, a Seattle-based financial adviser for Charles Schwab & Co.

Time your purchase

When buying dividend-paying mutual funds, the tax-conscious investor should also be mindful of year-end distribution dates.

Why? Mutual funds are required to distribute at least 98 percent of their income and gains to shareholders each year, prompting many to make large dividend payments in December.

In tax-deferred accounts, this won't make any difference to the investor. However, in taxable accounts it will because these distributions are treated as income, even if the investor reinvests them in more shares instead of receiving them in cash.

"If you're buying a mutual fund between September and November, check to see whether it's paying a big capital gains distribution, and if it is, you might want to wait until after (the distribution)," says Catherine Taylor, vice president and counsel of the corporate tax division for Ameriprise Financial in Minneapolis. "You don't want to 'buy the dividend.'"

Mutual fund investors who have assets in both taxable and tax-deferred accounts can better their odds of enjoying a comfortable retirement by taking an interest in tax efficiency.

"In the markets, there are many factors that are outside of an investor's control, but one area where investors can have a direct impact on performance is tax planning," says Rawson.


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