The tax cost ratio measures how much a fund’s annual return is impacted by taxes that the investors must pay on dividends, distributions and capital gains returned during the year. Like the expense ratio, the tax cost ratio is a variable that investors must consider when choosing which funds to invest in and what types of accounts should hold such investments.
It can be helpful in understanding tax cost ratio by comparing the tax ramifications of a mutual fund to, say, a single stock. Investors holding a single stock have to pay taxes on the stock only in two scenarios: if a dividend is received, or if the investor sells the stock for a profit. Those are the two “taxable events.”
In contrast, an investor holding a mutual fund may incur a tax liability just simply by holding the fund. The reason for this is that fund investors must pay taxes when incurring taxable events from the holdings within the fund. This can include dividends from the stocks inside the fund, interest received from the bonds within the fund and capital gains from a stock that is sold by the fund manager inside the fund.
In analyzing funds, you can typically get a good feel for how tax efficient the fund may be. First, a high turnover of positions within the fund will reveal that the fund is likely not going to be very tax efficient. Additionally, when researching a fund, you can often compare the pretax return against the tax-adjusted return.
Moreover, the tax cost ratio is often listed for potential funds in 1-year, 3-year, 5-year and 10-year increments. Most equity funds have tax cost ratios in the 1% to 1.2% range. This means that in a given year, holders of the fund would be losing 1% to 1.2% of their assets due to tax liability. Bond funds might have a tax cost ratio more in the 3% to 4% range. Bond funds typically incur more of a tax hit because most of the return in these funds is centered around interest payments.
A logical conclusion of the discussion of tax cost ratio and how tax efficient various types of funds are is that certain types of funds should be kept in certain types of accounts. It’s common wisdom in investor crowds to keep your bond funds in your tax-sheltered accounts and keep your equity funds in your taxable accounts. Since most people often hold more of their assets in equity funds versus bond funds, this usually isn’t a problem. For retirees with a heavy bond fund allocation, this might be more difficult.
How is the tax cost ratio calculated?
At a high level, the tax cost ratio is typically calculated by dividing the aftertax return of a fund by its pretax return. The following formula can be used:
tax cost ratio = (1 – ((1 + after tax return)/(1 + pretax return))) x 100%
Let’s look at an example. If Fund ABC has a annual pretax return of 7.5% and an aftertax return of 6.5%, we can calculate the tax cost ratio as follows:
tax cost ratio = (1 – ((1 + .065)/(1 + .075))) x 100%
tax cost ratio = (1 – (1.065/1.075)) x 100%
tax cost ratio = (1 – .991) x 100%
tax cost ratio = .009 x 100%
tax cost ratio = .9%
Are mutual funds tax efficient?
In general, mutual funds are not considered highly tax efficient. With that said, however, some mutual funds are more tax efficient than others depending on their objectives and the skill of the fund manager. To compare the tax efficiency between mutual funds, we analyze the tax cost ratio (explained above) and look at other metrics such as the pretax vs after tax returns.
Typically mutual funds are less tax efficient when compared to, say, ETFs because they are more actively managed and have a higher turnover rate of the assets and holdings within the fund. The higher turnover means more taxable events are occurring, and thus the investor is hit with a more regular tax bill.
Additionally, it’s important to understand the actual structure of mutual funds because it has ramifications for tax efficiency. Unlike a stock or an ETF that trades on an exchange, when you put money into a mutual fund, you’re buying shares of the fund from the mutual fund company itself. Unless labeled a “closed end fund,” the mutual fund is open ended and means investors can buy or sell shares at anytime from the mutual fund company. So how does this relate to tax efficiency? Well, if a large number of investors sell their shares in a particular mutual fund, it could mean that the fund manager is forced to sell part of the fund’s holdings in order to have enough cash to buy back the shares being redeemed. This creates a taxable event for anyone holding the mutual fund.
There’s one more tax-related topic with regards to mutual funds that investors may hear mentioned from time to time. It’s the topic of “phantom gains.” The idea of phantom gains comes from when a mutual fund manager sells a position inside the fund which incurs capital gains for shareholders of the fund. If an investor buys into the mutual fund just before such a sale occurs, the investor is essentially incurring a taxable event without the benefit of the underlying asset appreciation that has been occurring (because they just recently bought into the fund).
While this might sound overly negative, it’s important to realize that mutual funds are still some of the most popular investment vehicles out there. And mutual fund managers are aware of the tax implications. While the funds typically distribute the net gains and dividends to investors at the end of the year, they also will attempt to sell other losing positions to offset any gains in order to minimize the tax burden of shareholders.
Are ETFs tax efficient?
When the ETFs are equities or stock-based ETFs, they are considered to be more tax efficient in general than mutual funds for two primary reasons. First, ETFs tend to have less turnover of holdings inside the fund. ETFs typically follow a market index (such as the S&P 500) or a sector index (such as the energy sector). The only turnover of positions is when companies are added or removed from the underlying index that the ETF is tracking. Contrast this with active management of a mutual fund.
Additionally, ETFs are not structured like mutual funds in that when you buy shares of an ETF, you are not sending your money to the ETF company in return for shares of the ETF. Instead, you’re buying shares of the ETF on the open market from other shareholders similar to how stocks are traded. This avoids the scenario where positions need to be sold in order to raise cash for investors bailing on the mutual fund (as described above).
Note that bond ETFs are not generally considered tax efficient because bonds are not considered to be tax efficient. The reason for that is because the primary method of generating return on bonds is the payment of interest which is taxable. So, the underlying bonds of a bond ETF will incur taxation via the interest the bonds are generating. Bond ETFs also generally have more turnover compared to equity based ETFs. For this reason, many investors try to keep bond ETFs and bond funds in general in tax-sheltered accounts.
Are target date funds tax efficient?
Target date funds have become popular investment vehicles in recent years. Target date funds, at a high level, are funds that adjust its allocation over time based on a target date, typically shifting towards a more conservative (or bond-centric) allocation as the target date approaches. If an investor thinks they’ll retire in 2040, they can invest in a 2040 target date fund that will shift its allocation towards more bond holdings as 2040 approaches, thus mimicking recommended asset allocation strategies by age group.
Tax cost ratio and tax efficiency is a relevant topic for target date funds as well. The good news for these funds is that typically they hold index funds to achieve the targeted asset allocation. This means that the funds being held inside the fund are not actively trading too much and turnover is limited. While capital gains and dividends can be a part of these funds, they typically are somewhat tax efficient.
Overtime, however, these funds “rebalance” as the allocation shifts, typically from a high equities allocation to an increased bond allocation, this can require selling stocks and purchasing bonds. These have the potential of generating taxable capital gain distributions.
With regards to tax efficiency, what’s better: Target date funds or a three fund portfolio?
While we just discussed that target date funds are typically not terrible with regards to tax efficiency, I prefer the three fund portfolio approach and splitting the funds up across the appropriate accounts for maximum tax efficiency.
The three fund portfolio typically has an allocation of US equities, international equities and bonds. By using this approach, the investor can put the least tax efficient aspect of the portfolio into a tax sheltered accounts such as an IRA or 401(k). This would be the bond funds. Then, US equities and international equities funds can be in the taxable accounts (as well as tax sheltered accounts).
A word about REIT funds
The tax cost ratio topic has an added wrinkle when consider REIT funds. REITS, or real estate investment trusts, are popular with some investors as a way to add an “alternative” into their portfolio mix, especially for investors who are seeking investment income. REITs often have decent income yields, but note that many REIT funds distribute non-qualified dividend income which is taxable as ordinary income. Thus, you can expect a higher tax cost ratio for such funds especially if you’re in a higher tax bracket.
Let’s look at a practical example of a REIT fund and how we might calculate its tax cost ratio. If you consider Vanguard’s Real Estate Index Fund Investor Shares fund (VGSIX), we can look at the tax data as provided by Morningstar (note that some say Morningstar’s tax data isn’t always perfect, so consider comparing it with other sources).
The 5-year pretax annual return of VGSIX is 8.75%. The tax-adjusted return over the same time period is 7.25%. If we use this data to calculate the tax cost ratio using the formula described above, it looks like this:
tax cost ratio = (1 – ((1 + .0725)/(1 + .0875))) x 100%
tax cost ratio = (1 – (1.0725/1.0875)) x 100%
tax cost ratio = (1 – .9862) x 100%
tax cost ratio = .0138 x 100%
tax cost ratio = 1.38%
Like other variables, the tax cost ratio is one of many considerations when making investment decisions. For most investors, keeping a simple portfolio strategy that perhaps breaks up funds into taxable and tax-sheltered accounts is all the tax efficiency work you need to do. The below graphic explains some basic rules to consider about which funds and investment vehicles work best in what types of accounts:
For others looking to eke out minor gains anywhere they can be found, more advanced tax cost ratio calculations could be examined at the fund level.