One of the investing lessons I learned the hard way involves taxes. When I first started investing outside of retirement accounts, I didn’t consider how tax efficient the funds were that I had selected. For starters, I was only investing about $100 a month. And because I had no intention of selling the funds, taxes just didn’t seem all that important.
Fast forward about 15 years, and these small contributions had grown into a significant investment portfolio. And I quickly came to dread December as far as investments were concerned. It was in December that my funds would declare dividends and capital gains. Dividends, like dividends you may receive from your investment in individual stocks, represent the dividends paid out by the companies owned by the fund. Capital gains are a tad more complicated when it comes to mutual funds, but the key is to understand that owning a fund can result in capital gains tax even if you haven't sold any of your shares in the fund.
The takeaway here is that if you invest in mutual funds in a taxable account, it's important to consider the fund's tax efficiency as part of your assessment of the mutual fund. Fortunately, Morningstar makes this easy to do.
Morningstar’s Tax Cost Ratio
Morningstar has developed a method to evaluate a fund’s tax ramifications and to compare the results to other funds. In Morningstar, search for a fund using the fund’s ticker symbol, and you’ll see a “Tax” menu item toward the top right of the results. One of the funds I own is the Vanguard Emerging Mkts Stock Index (VEIEX). When you click on the “Tax” menu item, the following table appears:
Morningstar does a nice job explaining what each row represents. While the pretax return is obvious, here is Morningstar’s explanation of how it calculates tax-adjusted return:
Tax-adjusted returns and tax cost ratio are estimates of the impact taxes have had on a fund. We assume the highest tax rate in calculating these figures. These returns follow the SEC guidelines for calculating returns before sale of shares. Tax-adjusted returns show a fund’s annualized after tax total return for the three-, five-, and 10-year periods, excluding any capital-gains effects that would result from selling the fund at the end of the period. Fund loads are also subtracted from the figure. To determine this figure, all income and short-term capital gains distributions are taxed at the maximum federal rate at the time of distribution. Long-term capital gains are taxed at a 15% rate. The after tax portion is then assumed to be reinvested in the fund. State and local taxes are not included in our calculations. For tax-exempt funds, we only adjust for capital gains tax, as the income from these funds is almost always nontaxable.
For domestic stock funds, which report income that qualifies for a lower tax rate under the dividend tax cut enacted in 2003, we apply the lower rate consistent with that legislation. In practice, however, most fund companies do not specify if their distributions are eligible for this lower rate. Further NASDAQ, which supplies the raw daily data feed on distributions and NAVs for mutual funds, is not currently equipped to distinguish between income distributions that are eligible for the lower rate and those that are not. For funds that do not make such a distinction in their direct reports to us, we therefore must adjust their after-tax returns using the maximum federal rate. As a result, since most stock dividends qualify for a lower tax rate, some domestic stock funds with sizable yields may have understated after-tax returns in our system.
The percentage rank in category gives you an easy way to compare one fund to others. But it’s the Tax Cost Ratio number that really comes in handy. Basically, the Tax Cost Ratio represents how much of a fund’s return you lose to taxes each year. In an ideal world, you wouldn’t have to pay any taxes unless and until you decided to sell some or all of your shares. That’s exactly how an investment in an individual stock works assuming the company doesn’t declare any dividends. Here is Morninstar’s description of the Tax Cost Ratio:
This represents the percentage-point reduction in an annualized return that results from income taxes. Mutual funds regularly distribute stock dividends, bond dividends, and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.
The tax cost ratio is a measure of how one factor can negatively impact performance. The ratio is usually concentrated in the range of 0-5%. 0% indicates that the fund had no taxable distributions and 5% indicates that the fund was less tax efficient.
For example, if a fund had a 2% tax cost ratio for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)
With the Tax Cost Ratio, it's easy to compare one fund to another. For example, while VEIEX is a reasonably efficient fund when it comes to taxes, Vanguard's International Explorer Fund (VINEX) is not so kind:
You’ll notice that with this fund, the Tax Cost Ratio is notably higher, but the Cap Gains Exposure % is low. This exposure percentage indicates what portion of a fund’s assets represents gains. This can be important to know ahead of investing in a fund to avoid any nasty tax surprises. Here’s Morningstar’s full description of its Cap Gains Exposure %:
Potential capital gain exposure is an estimate of the percent of a fund's assets that represent gains. Potential capital gain exposure measures how much the fund's assets have appreciated, and it can be an indicator of possible future capital gain distributions.
The key here is to be mindful of taxes when you are investing in taxable accounts. Morningstar is a great place to start your analysis.
Related: Best Tax Software for Investors