Tallying The Taxman's Take

Is your mutual fund "tax efficient"?

You only have to look at your pay stub to know how much of your income is lost to taxes. But what's the tax bite on your mutual funds? It's an especially timely question since, by law, funds must distribute their net interest, dividends, and realized capital gains each year--and most of that is going to happen in the next two months.

Don't bother looking at your account statement. To come up with that figure, the fund company would have to know as much about your finances as your accountant or the Internal Revenue Service. Now, Vanguard Group, the No. 2 mutual-fund firm, is trying to address that by posting aftertax returns on its Web site (www.vanguard.com) and by introducing them into annual reports.

The move comes as no surprise to anyone who knows Vanguard. It built its franchise on higher returns through lower costs--and taxes, after all, are a cost. But aftertax returns can be misleading if you don't know how they were figured. Indeed, Vanguard's aftertax numbers probably bear little resemblance to your own unless you're a multimillionaire with an inept accountant.

To make this calculation, you have to assume a tax rate. Vanguard, employing a method long used by Morningstar in its publications and software, starts with a pretax return and then assumes all distributions were taxed at the highest federal rate at the time. Since 1993, that has meant 39.6% on income, dividends, and short-term capital gains. The top rate on long-term gains was 28% until mid-1997, and 20% since. Those are the assumptions in the aftertax returns in the accompanying table.

You don't have to be a CPA to see the shortcomings in this approach. First, few investors are in the 39.6% bracket, so this method will overstate the bite. In fact, in the BUSINESS WEEK Mutual Fund Scoreboard, which has featured aftertax returns on equity funds since 1994, we use a 31% tax bracket because it's a better estimate of the rate investors really pay. The other shortcoming is that such calculations--and that goes for BUSINESS WEEK's--don't include state taxes. Those can be substantial, especially in high-tax states such as California and New York. If you really want to know your aftertax return, you (or your accountant) must figure it out.

FREQUENT TRADERS. But these imperfect numbers do have value. For one thing, they treat all funds alike. That lets you examine the "tax efficiency" of a fund, or how much of the pretax returns survive Apr. 15. Take the three-year aftertax return on the Vanguard 500 Index Fund--24.09%. Divide it by the pretax return, 25.04%. You get a 96% tax-efficiency ratio, which is high. That's because index-fund managers don't trade the portfolio. More frequent trading drives up capital-gains distributions. So Fidelity Magellan Fund, which is trying to beat the market, loses more to taxes. Its ratio is just 92%.

That's not bad. A fund with a ratio of 90% or better seems safe enough for a taxable account. Less tax-efficient funds may be frequent traders, like American Century Ultra Fund. They may also be funds that favor dividend-paying stocks (Washington Mutual Investors Fund) or mix interest-bearing bonds into the portfolio (Vanguard Wellington Fund). Such funds might work best in a tax-deferred account such as an individual retirement account or a 401(k).

Lest you get carried away with tax efficiency, remember that pretax total returns come first. Paying taxes on a winning investment still beats paying none on a loser.

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