Unwanted Tax Consequences

There are three taxable events with a mutual fund: (1) sale of securities within the portfolio, (2) the declaration and payment of dividends and/or interest from the portfolio’s securities, and (3) sale of mutual fund shares. Your clients cannot control whether or not a fund is going to sell one or more securities for a profit or loss. Similarly, they cannot stop the payment of dividends and/or interest. The third event is the only one controllable by the shareholder. For example, in 2013 Vanguard S&P 500 Index Fund had a total return of 32.33%; 31.70% after taxes (98% tax efficiency).

Fortunately, there are things the advisor can do to minimize fund taxation. First, whenever possible, place tax-inefficient funds into IRA and/or other qualified retirement accounts. The ideal place for taxable bond funds, taxable money market accounts, and high-dividend-paying stock funds is sheltered accounts. All interest from regular money market funds is taxed as ordinary income; long term, most of a bond fund’s returns are from interest income (making both of these assets ideal candidates to shelter from current income since such interest is taxed as ordinary income).

Most domestic stock dividends qualify for the more favorable 0% or 15% tax rate (20% for very high-income taxpayers), but deferred taxation may still be the better way to go. Second, find out the fund’s tax efficiency by reviewing the prospectus or by using a mutual fund advisory service. Contrary to what the financial press believes, the vast majority of equity funds are quite tax efficient.