Tax Considerations in Investing


Investors Are Unaware of the Significance of Taxes

Many Investors are unaware of just how significant a problem taxes can pose to their long-term returns. In a telephone survey by the Dreyfus Corporation, one thousand mutual fund investors were questioned about their tax knowledge. Eighty-five percent of respondents claimed taxes play an important role in investment decisions, but only 33% felt that they were knowledgeable about the tax implications of investing. Eighty-two percent were unable to identify the maximum rate for long-term capital gains.

Taxes on realized (distributed) capital gains, dividends, and interest can be significant. It is estimated that the average active mutual fund investor loses about three percentage points of return to taxes every year. The more an investor earns in active mutual funds, the higher the taxes. This reduces the potential for wealth, which defeats the purpose of investing. A study conducted by Stanford University measured the performance of 62 equity funds for the period from 1963 through 1992.

It found that although each dollar invested in this group of funds would have grown to $21.89 in a tax-deferred account, the same amount of money invested in a taxable account would have produced only $9.87 for a high-tax-bracket investor. Taxes cut returns by 57.5%! Index funds, however, have low portfolio turnover and their capital gains distributions are also very low, thereby reducing the impact of taxes.

Managers of Active Funds Seem to Manage Money as if Taxes do not Matter

Since active fund managers tend to be evaluated and rated based on their pre-tax returns, they do not have an incentive to pay much attention to the tax impact of their trading. As a result, managers of active funds today often disregard the high taxes generated by their stock picks and market timing, not to mention the adverse effect on fund performance. Realized capital gains taxes are not reflected in active mutual fund performance ratings thereby catching the average active mutual fund investor by surprise.

Taxes do Matter

Instead of being distributed and taxed, unrealized capital gains are profits that have not yet been realized for tax purposes; taxes need not be paid on these gains. Unrealized capital gains remain a growing part of the net asset value of a fund’s share rather than being distributed to the investor. The index fund manager minimizes portfolio turnover, and so maximizes unrealized capital gain. When stocks in an active fund increase in value and are sold for a profit by the fund’s manager, the result is that the fund actually realizes gains as opposed to simply reporting an increase in the value of the portfolio, and investors pay both ordinary income and capital gains taxes on those distributions. On the other hand, by the time an investor is ready to realize an investment in an index fund, it will be a long-term capital gain, untaxed for years. Realized long-term capital gains have a much lower tax rate.

As might be expected, taxes affect active fund performance, not only earnings. Stanford University released the results of a 30-year study in 1993 that examined the difference between the average pre-tax, after-tax, and liquidation performance of 62 actively managed stock mutual funds. Pre-tax performance assumes reinvestment of all distributions, after-tax assumes reinvestment of distributions left after taxes have been paid, and liquidation is selling out completely and paying all taxes, rather than reinvesting in the fund. The study also took into account differing tax brackets, whether high (55% taxes paid), medium (41%) or low (25%). According to the study’s results, between 1963 and 1992 it was found that a high tax bracket investor who reinvested after-tax distributions ended up with an accumulated wealth of 45% of the fund’s published performance. Investors in a middle tax bracket realized 55% of published performance.

As mentioned earlier, actively managed mutual fund advertisements and published ratings feature only pre-tax returns, often misleading investors. In fact, Robert Jeffrey and Robert Arnott proved with their 10-year study titled “Is Your Alpha Big Enough to Cover its Taxes?” that on an after-tax basis, index funds outperformed 97% of active mutual funds. They also found that although 71 active funds tried to beat the market with high turnover efforts, the added returns did not outweigh the resulting taxes.

More Information about Tax-Managed Funds

A tax efficient or tax-managed mutual fund means that the published return and the after-tax return should be similar since there are minimal taxable distributions from the fund. Index funds can be tax-managed, in addition to the natural advantages of low turnover in the index fund. Managers of tax-managed index funds employ tax-managed trading strategies such as tax loss harvesting of stocks that large losses, while most managers of actively manage funds have high turnover of their stocks and manage the fund as if taxes were not important to their performance. Since few investors adjust their returns by the taxes they pay on the fund, the active managers prefer not to worry about taxes. However, they can have a significant impact on your returns.

The charts below show comparisons between IFA Index Portfolios and IFA Index Portfolio for Taxable Accounts.




The names in the table below are links to fact sheets about each of these Tax-Managed funds.

 DFA Tax Managed Funds Prospectus Tax-Managed US Targeted Value
 Tax-Managed US Small Cap
 Tax-Managed US Market Wide Value  Tax-Managed DFA International Value  Tax-Managed US Equity