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Breaking a Tie Between Funds

Step 1: What If Fund Returns Are Similar?

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Making tax avoidance your investment focus is a formula for investment disaster. But keeping your eye on aftertax returns is simply wise investing. For example, two funds have similar compound average annual five-year before-tax returns. A five-year period is probably long enough to get a picture of how the funds have performed in different market environments, but still recent enough to be relevant.

Classroom Steps


However, one fund wins on a tax-adjusted return basis for the period, producing a higher aftertax return. Why? The fund might have a lower yield, defined as income divided by net asset value, or simply made less or no distributions of capital gains. Interest earned by the fund from non-tax-exempt sources is taxable at ordinary income tax rates. Municipal bond interest is usually not taxable at the federal level and may not be taxable at the state or local level, if the fund is a state-specific municipal bond fund. Qualified dividend income from stocks held by the fund is subject to the lower long-term capital gains rate. With long-term capital gains rates (on securities sold by the fund but held by the fund for longer than one year) significantly lower than short-term capital gains tax rates, the tax penalty on short-term capital gains is serious. And no capital gains distributions means no taxes, even at the lower capital gains rate. The tax-adjusted return assumes maximum tax rates, where the disparities between capital gains tax rates and income tax rates are the greatest. For investors in lower tax brackets, the tax-adjusted rate difference might not be great.

 

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