Is Your Fund Tax Friendly?
The Vanguard Group
At the end of the day, it's not your
fund's total return that matters but the after-tax return you pocket (assuming your fund is held in a
taxable account). When determining whether a fund may reduce your tax liability, consider these factors:
Holdings
Does your fund own taxable bonds? If it's a stock
fund, is producing income one of its main objectives? Such
funds are likely to make regular distributions to you that will be
taxed as ordinary income. On the other hand, if your fund holds
low-yielding growth stocks, you may face fewer income
distributions and more capital gains distributions, which are
taxed at a lower rate.Turnover Rate
Does your fund maintain a buy-and-hold
approach, or does the fund frequently buy and sell securities?
The best indication of a fund's trading activity is its turnover
rate, which measures the frequency with which securities are
bought and sold during a year. A high turnover rate in a strong
market increases the likelihood that a fund will realize its gains
and distribute them to shareholders.Taxes are not entirely avoidable. When you redeem your fund shares,
you will owe capital gains taxes, assuming the investment appreciated in value.
But you want to avoid a heavy tax burden while you own your
shares. Those annual tax bites eat away at the amount of money you
have available to invest and grow over time. Traditional IRAs are
attractive because taxes are deferred until you retire. Roth IRAs offer
other tax advantages if certain criteria are met. A tax-friendly fund in a
taxable account should offer the same benefit—a minimal tax bite, or
no taxes at all, until you withdraw your money from the account.
By investigating a fund's holdings and turnover rate, you can gain
some control over taxes on your investments and, ultimately, your
return. The following table may help you weigh tax
considerations when selecting funds:
| Type of Fund |
Potential for Income Taxes |
Potential for Capital Gains or Losses |
| Taxable Money Market |
High |
None |
| Tax-exempt money market |
Very low* |
None |
| Taxable bond |
High |
Low |
| Tax-exempt bond |
Very low* |
Low |
| State tax-exempt bond |
Very low |
Low |
| Balanced (stocks and bonds) |
Medium |
Medium |
| Value stock |
Medium to low |
Medium to high |
| Growth stock |
Low |
High |
| International stock |
Medium to low |
High |
*While income from tax-exempt money market or bond funds generally
is not subject to federal income tax, all—or a portion—of the income
may be subject to state tax.
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