Investing in tax-efficient funds.

• Author: Ellentuck, Albert B.

A mutual fund's "tax efficiency" refers to how the fund's operations affect when income will be distributed and taxable to shareholders. Tax efficiency can affect the overall net return a shareholder realizes from a mutual fund and is often one of the factors investors consider when selecting such investments. Tax efficiency is more likely to be a factor in funds holding stocks and other equity instruments, not when selecting mutual fund investments in retirement accounts like Sec. 401(k) plans and IRAs (and other tax-deferred accounts, such as variable annuities).

Definition

Tax efficiency is essentially a function of a fund's portfolio turnover rate. "Turnover rate" is how often a fund sells (turns over) its portfolio. Generally, funds with high turnover rates are less efficient than those with low turnover rates; the disposal of securities causes the fund to recognize gain on appreciation. Because mutual funds must distribute virtually all of their income to shareholders each year, the more income a fund recognizes in a year, the more income shareholders must report.

Generally, the more tax efficient a fund is, the less current income a shareholder recognizes. In addition, many of the gains recognized by funds with high turnover rates are likely to be short-term rather than long-term and, thus, not eligible for the preferential capital gains rate.

Index Funds

Index funds tend to be more tax efficient than other mutual funds. Stocks held by an index fired normally replicate a particular securities market benchmark (e.g., the S&P 500 stock portfolio). Thus, the fund is not actively managed like funds with specific fund objectives. Index funds generally use a buy-and-hold approach to investing--selling securities only when cash is needed to redeem shares. They hold, rather than sell, appreciated securities; as a result, gains are generally unrealized. Index funds generally have a low turnover rate, which minimizes the current taxable income distributed to shareholder.

In addition to a lower portfolio turnover rate, index funds typically have lower management fees than do activity managed funds. Over a long investment period, the combination of lower turnover and fees can significantly enhance an index fund's overall return when compared to an actively managed fired.

Retirement Assets

As was mentioned, a fund's tax efficiency is not an issue when selecting mutual funds for retirement account assets. This is an important consideration when...