Image: Taxes © Peter Gridley, Photographer

Thus far, we have lauded mutual funds' virtues. They don't require a large up-front investment. They're professionally managed. They're easy to buy and sell. And if you shop carefully, you can limit how much you have to pay to own them.

But there is one thing that mutual funds may not be: tax-friendly. We'll explore reasons for this weakness, and examine ways you can minimize its impact on your bottom line.

Funds, capital gains and income

As noted, mutual funds must pass along to their shareholders any realized capital gains that are not offset by realized losses by the end of their accounting year. Mutual fund managers "realize" a capital gain whenever they sell a security for more than they paid for it. Conversely, they realize a loss when they sell a security for less than the purchase price. If gains outweigh losses, the managers must distribute the difference to fund shareholders.

Fund managers must also distribute any income that their securities generate. Bond funds typically pay out yields, but so do some stock funds if the stocks they own pay dividends.

As you may recall, when paying out capital gains or income, funds multiply the number of shares you own by the per-share distribution amount. You'll receive a check in the mail for the amount of the distribution. Or, if you choose to reinvest all distributions, the fund will instead use the money to buy more shares of the fund for you. After the distribution is made, the fund's NAV will drop by the same amount as the distribution. Fund companies often make capital-gains distributions in December, but they can happen anytime during the year.

Distributions and taxes

Unless you own your mutual fund through a 401k plan, an IRA or some other type of tax-deferred account, you'll owe taxes on that distribution -- even if you reinvested it (used the distribution to buy more shares of the fund). That is particularly painful if you have just purchased the fund, because you are paying taxes for gains you didn't get.

Let's use an example to illustrate. Suppose you invest $250 in Fund D on Monday. The fund's NAV is $25, so you are able to buy 10 shares. If the fund makes a $5-per-share distribution on Tuesday (which means you have been handed a $50 distribution), and you reinvest, your investment is still worth the same $250:

 
Monday 10.0 shares @ $25 = $250
Tuesday12.5 shares @ $20 = $250

The trouble is, you now owe capital-gains taxes on that $50 distribution. The current long-term capital-gains tax rate is 15% for anyone in the 25% or higher bracket and 5% for those in 10% to 15% brackets. If you're in the higher tax bracket, you'd have to pay $7.50 in taxes on that long-term capital gain. (Shorter-term capital gains are taxed at a higher rate.)

If you immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. The distribution lowers the NAV, so the amount of taxes you would pay would be lower than if you sold the fund years from now. Still, most investors would rather pay taxes later than sooner. And we're guessing that if you just invested in the fund, you weren't planning to turn around and sell it right away.

Funds occasionally can add insult to injury by paying out a large capital-gains distribution in a year in which the fund lost money. In other words, you can lose money in a fund and still have to pay taxes. In 2000, for example, many technology funds made big capital-gains distributions, even though almost all of them were in the red for the year. Although the funds lost money during the year, they sold some stocks bought at lower prices and had to pay out capital-gains as a result. Technology-fund investors lost money to both the market and Uncle Sam that year.

Avoiding overtaxation

Alleviate tax headaches by following these tips:

  • Tip 1. Ask a fund company if a distribution is imminent before buying a fund, especially if you are investing late in the calendar year. (Funds often make capital-gains distributions in December.) Find out if the fund has tax-loss carry-forwards -- that is, if it has booked capital losses in previous years that can be used to offset capital gains in future years. That means the fund could be tax-friendly in the future.
  • Tip 2. Place tax-inefficient funds in tax-deferred accounts, such as IRAs or 401k's. If a fund has a turnover rate of 100% or more, it's a good indication that limiting the tax collector's cut isn't one of the manager's objectives.
  • Tip 3. Search for extremely low-turnover funds -- in other words, funds in which the manager isn't doing a lot of buying and selling and therefore isn't realizing a lot of taxable capital gains. A fund with a turnover rate of 50% isn't four times more tax-efficient than a fund with a 200% turnover rate. But funds with turnover rates below 10% tend to be tax-efficient. You can find turnover rates on Morningstar, as well as in your fund's annual report.
  • Tip 4. Favor funds run by managers who have their own wealth invested in their funds, such as Marty Whitman of Third Avenue Value (TAVFX +0.55%, news)or the managers of Tweedy, Browne Global Value (TBGVX +0.32%, news). These managers are likely to be tax conscious because at least some of the money they have invested in their funds is in taxable accounts. The Securities and Exchange Commission will soon require fund families to disclose whether their managers have a stake in the funds they manage and, if so, how much.
  • Tip 5. If you want to buy a bond fund and are in a higher tax bracket, consider municipal-bond funds. Income from these funds is usually tax-exempt.

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Even when you follow these tips, it can be difficult to find a fund that's consistently tax-efficient. But don't get so caught up in tax considerations that you overlook good performance. After all, a tax-efficient fund that returns 7% after taxes is no match for a tax-inefficient fund that nets 15% after Uncle Sam takes his share. (You can find after-tax returns in our Fund Reports on Morningstar.com.) In the end, it is what you keep, not what you give away, that counts.