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After-tax returns
When you sell a mutual fund or other capital asset for a price that is higher than what you paid for it, you earn a profit. Your rate of return is the rate at which you earn a profit, stated as a yearly percentage. Rate of return is useful for comparing the performance of your investments.
For example, if you buy 100 mutual fund shares at $10 a share and sell them for $12 a share one year later, your rate of return is 20%.
Let's look at how taxes reduce your rate of return on a mutual fund investment. Your rate of return after deducting taxes is called your after-tax return.
There are three main sources of returns that contribute to your rate of return: dividend and capital gains distributions and the change in the fund's share price.
Mutual funds are required to distribute dividends and capital gains. Each source is taxed differently. Short-term capital gains are taxed as ordinary income. Dividends and long-term capital gains (i.e., gains on assets that the fund has held for longer than one year) are taxed at a rate of 5% or 15%, depending on your tax bracket.
Let's look at an example. Assume you are in the 25% income tax bracket and qualify for the 15% capital gains rate. If you sell 100 shares for $15 that you paid $10 for 366 days ago and which earned $100 in dividends, your after-tax return is based on paying 15% of $500 in capital gains and 15% on the $100 in dividends. After taxes, this equals $510. Divided by your $1,000 investment, your after-tax return is 51%.
Unfortunately, as a mutual fund shareholder, you have little control over distributions the fund makes. Funds sell some of their holdings when they redeem shares or lock in profits. Some funds have a high portfolio turnover ratio, which means they buy and sell funds more frequently than funds with a low ratio. More trading, or "churning," of a fund's portfolio implies that the fund realizes more capital gains than a fund that trades less often.
One way of comparing the after-tax returns of a mutual fund is to look at a fund's tax efficiency ratio. The simplest way of using this ratio is to divide the fund's after-tax return by its before-tax return. For example, if a mutual fund earns 5% after taxes and 8% before taxes, its tax efficiency is 62.5%.
As of 2002, the Securities and Exchange Commission requires mutual funds to show investment returns on an after-tax basis in their prospectuses. They are also required to show after-tax returns in their fund-marketing literature if they purport to manage funds in a tax-efficient way.
The SEC determined that investors lose about twenty percent of before-tax returns to taxes. In other words, an investor who earns a 12.5% return before taxes is likely to earn only 10% on an after-tax basis.
The new ruling requires mutual funds to disclose after-tax returns for periods of:
- One year
- Five years
- 10 years
After-tax returns are shown for the highest income tax bracket. For 2007, that bracket is 35%. While only a small percentage of taxpayers are taxed at this bracket, the SEC adopted a single bracket to simplify reporting requirements and to provide investors with the worst-case scenario of returns.
The SEC ruling requires that after-tax returns be based on an initial investment of $1,000 and that returns are calculated after deducting the maximum sales load and other charges from the initial investment.
The following table shows after-tax returns and tax-efficiency ratios for ABC Fund. To simplify, we assume all distributions are dividends:
The table shows that the tax efficiency ratio for all three is the same at 85% (one minus a dividend tax rate of 15%.)
One way to avoid tax-related concerns for now, of course, is to invest in funds through a 401(k) plan or other tax-deferred retirement account such as an IRA. These accounts let you defer paying income taxes until you begin taking money out of the account, which you usually do after you reach age 59-1/2.
A downside of using a tax-deferred account is that your distributions are taxed as ordinary income. A taxable account lets you benefit from a lower rate on a mutual fund's capital gain distributions. However, the benefit of deferring taxable income 10, 20 or more years often outweighs the disadvantage of having all earnings eventually taxed as ordinary income.
Next, we look at how mutual fund fees and loads affect investment returns.
Next Topic: Fees & loads
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