Tax-Saving Funds

For mutual fund investors, sharing less with Uncle Sam is a little trickier because a lot of portfolio managers aren't concerned about taxes.

For mutual fund investors, sharing less with Uncle Sam is a little trickier because a lot of portfolio managers aren't concerned about taxes. Their shareholders may be endowments and foundations, which pay few taxes, or individuals who invest through tax-deferred IRAs and 401(k) plans.

In addition, a manager's strategy may require frequent buying and selling of shares. Any capital gains from those transactions that can't be offset with losses have to be passed on to shareholders, who must then suffer the tax consequences.

A fund full of growth stocks should, in theory, be fairly tax-efficient, particularly if the manager is careful to match sales of winners with sales of losers to offset potential taxable gains. For example, T. Rowe Price Science and Technology (PRSCX; 800-638-5660) hasn't made a taxable distribution in eight years because it has been able to use substantial losses suffered from 2000 to 2002 to offset subsequent gains.

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But value funds, too, can come with a tiny tax bill if the manager uses a low-turnover strategy. Taxable distributions by Kiplinger 25 member Selected American Shares (SLASX; 800-243-1575) have historically been minuscule.

The best choices for tax-conscious investors are index funds. That's because they track relatively stable portfolios that seldom change. Fewer transactions translate into few taxable gains.

For extra tax protection, consider a tax-managed fund. These are funds that explicitly promise to take taxes into account when managing the portfolio.

For example, Michael Buek, manager of the Vanguard Tax-Managed Capital Appreciation fund (VMCAX; 800-635-1511), buys low-dividend stocks from the Russell 1000 index, holds them a long time and carefully matches investment gains and losses. The 13-year-old fund has never made a capital-gains distribution while managing to beat the return of its benchmark over the past five- and ten-year periods.

Benefitting from careful management

Tax-efficient funds strive to minimize distributions by trading infrequently and by matching losses with gains. Vanguard Tax-Managed Growth & Income, for example, returned less than the average large-blend fund over the past five and ten years.

But after taxes on distributions are taken into account, you end up with more in the Vanguard fund. Note, however, that you lose some of the advantages of tax efficiency once you sell your fund and pay taxes on your gains.

Swipe to scroll horizontally
Row 0 - Cell 0 Row 0 - Cell 1 Length of holding period
FundRow 1 - Cell 1 5 years10 years
Vanguard Tax-Managed Growth & IncomeGrowth of $10,000 before taxes$18,221$17,756
Row 3 - Cell 0 After-tax value before liquidation17,95617,087
Average Large-Blend FundGrowth of $10,000 before taxes18,23118,158
Row 5 - Cell 0 After-tax value before liquidation17,38816,137
How much more the tax-managed fund is worth$568$950

For more ways to make more and keep more ...

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Tax-Free Bonds

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Smart Planning

Four Tax Truths for Investors

Jeffrey R. Kosnett
Senior Editor, Kiplinger's Personal Finance
Kosnett is the editor of Kiplinger's Investing for Income and writes the "Cash in Hand" column for Kiplinger's Personal Finance. He is an income-investing expert who covers bonds, real estate investment trusts, oil and gas income deals, dividend stocks and anything else that pays interest and dividends. He joined Kiplinger in 1981 after six years in newspapers, including the Baltimore Sun. He is a 1976 journalism graduate from the Medill School at Northwestern University and completed an executive program at the Carnegie-Mellon University business school in 1978.