Tax Terms That Mutual Fund Investors Should Know

InvestWhew ? another tax return finished. No more IRS-related headaches till next year.

Well, maybe. Don’t let the relief you feel now cost you money as an investor. Too many people pay the government too much because they don’t think enough about the taxes on their mutual funds. They focus on a fund’s return ? but taxes can be the biggest drag on performance.

Many investors lose 1 or 2 percentage points of their fund returns every year because they don’t try to lower their taxes, says Tom Roseen, an analyst with fund tracker Lipper Inc.

The first step is to start educating yourself about the tax issues that can affect mutual funds. That’s not as hard as it might seem.

“You don’t need a Ph.D. in taxation to add substantially to your after-tax returns,” says Duncan Richardson, chief equity investment officer for investment manager Eaton Vance Corp. in Boston.

With that goal in mind, here are some key tax terms and strategies that fund investors should know:


These funds, sometimes called tax-advantaged funds, use a variety of techniques aimed at keeping taxes low. Their strategies include holding stocks for longer periods to defer taxable gains as long as possible. They also invest in lower-dividend-paying stocks to minimize capital gains. And they offset gains by selling other stocks at a loss.

Investors tend to be more interested in funds like this after the market drops and they’re feeling the pain of being hit by taxable distributions even during losing years. But tax-managed funds are worth a look at any point ? especially because federal taxes are expected to go up after next year. They by no means automatically sacrifice returns in exchange for their tax efficiency.

Exchange-traded funds also are generally tax-efficient, since they track indexes and thus their expenses and turnover tend to be lower.


A carry-forward, also known as a capital-loss carryover, is an accounting technique used to reduce the tax burden from a profitable fund. Think of it as stockpiling losses.

Mutual funds are required by the IRS to pass virtually all their capital gains along to investors. This means that regardless how bad a year it was in the market, investors face taxes for distributions from the long-term holdings their funds sold at a gain.

Funds are not allowed to pass along losses. But they can keep them on their books for up to eight years to offset future gains. This can be a boon to an investor who buys one of those funds, Roseen notes.

In other words, funds that stockpiled losses from bad times may be able to offset their taxable gains for years to come. That will lower investors’ taxes. If you buy one of these funds, you are using the fund’s losses to your benefit.

To find out about a fund’s carry-forwards, check the annual report of any fund or fund family.


Looking beyond a mutual fund’s pretax return is wise. Its after-tax figure may be where you want to focus.

“People always look at performance ? that’s what they want to see,” says Katie Rushkewicz, senior mutual fund analyst at Morningstar. “But sometimes taxes can be an issue.”

The Morningstar website, , offers a tax tab on each fund’s page that compares the fund’s pretax return with its tax-adjusted return. The tax-adjusted return accounts for capital gains, dividends and interest during the period.


A fund’s portfolio turnover ratio is the percentage of its assets that were sold during the most recent quarter or year. The more aggressive the fund, the higher the ratio. For example, a turnover of 300 percent means a fund sold portfolio of the securities it owned three times during the year. That raises the likelihood of capital gains taxes.

Unless the fund’s investing style justifies frequent trading, it’s a good idea to limit your tax consequences by avoiding funds that trade most of their holdings in a given year. That means being wary of turnover ratios above 50 percent.

Check fund reports or financial websites to find funds’ turnover ratios.


If you are wary of a big tax bill from a fund you are own are considering buying, its potential capital gains exposure can be a valuable tool. Potential exposure measures how much a fund’s holdings have grown in value. It tallies capital gains that haven’t been distributed to shareholders and divides that number by total net assets.

Morningstar developed the concept and its tax tab crunches each fund’s number. A higher number than most other funds may suggest a tax hit coming, while a negative number probably signifies tax efficiency.

But this one shouldn’t be the sole measure you use to choose or judge a fund. Richardson, whose Eaton Vance funds are big practitioners of tax management, compares it to trying to predict an earthquake.

“It’s an indication of the risk there, but it’s an imperfect science,” he says. “There are many things that can influence whether that exposure gets discharged.”

Source: The Associated Press.