Excerpted from the March 2007 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. For investors in mutual funds, tax season can be, well, taxing. The average domestic large-cap mutual fund cost its tax-sensitive clients about 0.65% in returns each year over the past three years, and the costs were even higher for U.S. small-cap (1.14%) and international funds (1.03%).1 To lessen the tax man's bite on your fund investments, consider the tax-smart strategies below. What's taxable First, remember that tax efficiency only matters if you're holding your funds in a taxable account. If you're investing in a tax-deferred account such as a traditional IRA or a 401(k), tax efficiency need not factor into your fund-picking decisions. However, within taxable accounts, there are three ways in which buying and holding a mutual fund can cause you to owe taxes, even if you reinvest all distributions and don't sell any shares of the fund. Dividends: When your fund holds stocks that pay out dividends, these dividends will ultimately be passed on to you. "Equity income" and "dividend equity" funds tend to pay out more dividends, and most of them pass along their dividends quarterly. Fortunately, most of these dividends qualify for favorable tax treatment and are taxed at a maximum rate of 15%. Dividends that don't qualify are generally from stocks that the fund held for a very short time, from certain foreign stocks or from investments such as real estate investment trusts (REITs).   Interest: Bond fund holders are likely to see monthly interest payouts. Unlike dividends, interest from taxable bonds is taxed as ordinary income with a maximum federal tax rate of 35%. If you're in a high tax bracket, consider a municipal bond fund, whose interest is exempt from federal and sometimes state income tax.   Capital gains: Any capital gains that your fund realizes (such as when the manager sells some stock for a profit) must ultimately be paid out to you, the shareholder. Generally, funds pay out their capital gains annually, mostly in December (more on this distribution later). If a fund sells stock that it held for one year or less, these short-term gains will be taxed at a maximum rate of 35%. Otherwise, long-term gains are taxed at a top rate of 15%. Consider these tax-smart tactics So how do you make tax-smart decisions when it comes to buying a fund? First, decide if you're in a high enough federal income tax bracket to prefer muni bonds over taxable bonds. If your federal tax rate is 28% or above, you'll generally do better with muni bonds. If you live in a high-tax state, you might consider a state-specific muni bond fund, which would be exempt from both federal and state income tax. However, if you're subject to the alternative minimum tax (AMT), beware of funds that invest in private activity muni bonds, whose interest is subject to the AMT. Next, you should look at your fund's tax cost ratio. This measures the amount of your return you would have lost to federal taxes in the past by holding this fund, assuming you were in the highest possible tax bracket. You can find your fund's tax cost ratio by logging in at Schwab.com, going to Quotes & Research, clicking on Mutual Funds, entering the fund's name or ticker symbol in the search box and then looking at the Risk & Tax Analysis tab. Compare your fund's tax cost ratio to its category average—ideally, your fund's tax cost will be well below average. But remember to consider your fund's other features (expenses, manager track record, etc.), as a fund can have a low tax cost ratio simply by losing money every year! If it's late in the year (November or December), check your fund company's Web site to see if the company has published information about estimated capital gains distributions. Fund managers who know that they're going to distribute a lot of gains will often let you know in advance. If that's the case, consider waiting to buy the fund until after it has paid its distribution—otherwise, you'll owe taxes on the whole distribution, without having participated in any of the gains. Finally, consider tax-loss carryforwards. If your fund realized losses (as many funds did in the bear market of 2000 to 2002), it can use those losses to offset future gains so that it doesn't have to pay distributions. While many funds have exhausted their bear market carryforwards, it is worth checking to see if your fund has any remaining. Looking for funds that we believe are tax-smart and well-managed? Start with the Mutual Fund OneSource Select List® and then screen for low tax cost ratios. Important Disclosures Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List®. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services. Schwab and its affiliates also receive fees from the Schwab Affiliate Funds for investment advisory, administrative and transfer agency services, as well as shareholder and other fund services. The aggregate fees Schwab or its affiliates receive from Schwab Affiliate Funds (see fund prospectuses for more details) are greater than the remuneration Schwab receives from fund companies participating in Schwab's Mutual Fund OneSource service. A bond fund's Net Asset Value will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed. Bond fund shares are subject to increased loss of principal during periods of increasing interest rates. 1. Source: Schwab Center for Investment Research® with data from Morningstar. Figures cited are asset-weighted average three-year tax cost ratios for all funds as of January 31, 2007. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment or investment strategy. All expressions of opinion are subject to change without notice. The Schwab Center for Investment Research is a division of Charles Schwab & Co., Inc. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses. This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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