Investing in tax-efficient funds.A mutual fund's "tax efficiency" refers to how the fund's operations affect when income will be distributed and taxable to shareholders. Tax efficiency can affect the overall net return a shareholder realizes from a mutual fund and is often one of the factors investors consider when selecting such investments. Tax efficiency is more likely to be a factor in funds holding stocks and other equity instruments, not when selecting mutual fund investments in retirement accounts like Sec. 401(k) plans and IRAs (and other tax-deferred accounts, such as variable annuities Variable annuities Investment contracts whose issuer pays a periodic amount linked to the investment performance of an underlying portfolio. ). Definition Tax efficiency is essentially a function of a fund's portfolio turnover rate. "Turnover rate" is how often a fund sells (turns over) its portfolio. Generally, funds with high turnover rates are less efficient than those with low turnover rates; the disposal of securities causes the fund to recognize gain on appreciation. Because mutual funds must distribute virtually all of their income to shareholders each year, the more income a fund recognizes in a year, the more income shareholders must report. Generally, the more tax efficient a fund is, the less current income a shareholder recognizes. In addition, many of the gains recognized by funds with high turnover rates are likely to be short-term rather than long-term and, thus, not eligible for the preferential pref·er·en·tial adj. 1. Of, relating to, or giving advantage or preference: preferential treatment. 2. capital gains rate. Index Funds Index funds tend to be more tax efficient than other mutual funds. Stocks held by an index fired normally replicate rep·li·cate v. 1. To duplicate, copy, reproduce, or repeat. 2. To reproduce or make an exact copy or copies of genetic material, a cell, or an organism. n. A repetition of an experiment or a procedure. a particular securities market benchmark (e.g., the S&P 500 stock portfolio). Thus, the fund is not actively managed like funds with specific fund objectives. Index funds generally use a buy-and-hold approach to investing--selling securities only when cash is needed to redeem shares. They hold, rather than sell, appreciated securities; as a result, gains are generally unrealized. Index funds generally have a low turnover rate, which minimizes the current taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. distributed to shareholder. In addition to a lower portfolio turnover rate, index funds typically have lower management fees than do activity managed funds. Over a long investment period, the combination of lower turnover and fees can significantly enhance an index fund's overall return when compared to an actively managed fired. Retirement Assets As was mentioned, a fund's tax efficiency is not an issue when selecting mutual funds for retirement account assets. This is an important consideration when choosing investments for taxable versus retirement accounts. An individual seeking to invest in both actively managed and index funds will generally benefit by using index funds for taxable investment assets and reserving actively managed funds for retirement assets. Tax-Managed Funds Some equity mutual funds are "tax-managed" funds, which seek to minimize taxes to shareholders by maintaining a low portfolio turnover rate and considering taxes when buying and selling securities. They often charge a redemption fee Redemption fee A fee some mutual funds charge when an investor sells shares within a specified short period of time. to investors who withdraw funds before a specified period (e.g., one year). Tax advisers with clients who want to minimize taxes through mutual fund investments might recommend such funds. Other Considerations When choosing mutual fund investments, investors must consider the fund's tax efficiency ha view of their particular tax situation. Many investors will want to minimize their current taxes and defer de·fer 1 v. de·ferred, de·fer·ring, de·fers v.tr. 1. To put off; postpone. 2. To postpone the induction of (one eligible for the military draft). v.intr. gain recognition to future years. This makes the mote (reMOTE) A wireless receiver/transmitter that is typically combined with a sensor of some type to create a remote sensor. Some motes are designed to be incredibly small so that they can be deployed by the hundreds or even thousands for various applications (see smart dust). tax-efficient funds tax-efficient fund A mutual fund that manages its investment portfolio so as to minimize the tax liability of its shareholders. A tax-efficient fund attempts to minimize capital gains distributions by reducing portfolio turnover and to minimize dividend the most appealing. However, investors with capital loss carryovers, excess investment interest or other unused deductions may benefit from a fund with a high turnover rate more likely to generate higher current taxable income. Of course, tax efficiency is only one factor in selecting a fund. The fund's overall expected performance and whether it meets the investor's personal financial planning Financial planning Evaluating the investing and financing options available to a firm. Planning includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in the form of a financial plan, and then comparing future performance against needs are likely to be more important. Example John Henderson
The name John Henderson may refer to:
in full American Broadcasting Co. Major U.S. television network. It began when the expanding national radio network NBC split into the separate Red and Blue networks in 1928. Growth Fund or the ABC Index Fund. The former is an actively managed fund with a 150% annual portfolio turnover rate. The latter is a passive fund that replicates the performance of the S&P 500; it has a very low portfolio turnover rate. John is in the highest ordinary income tax bracket Noun 1. income tax bracket - a category of taxpayers based on the amount of their income income bracket, tax bracket bracket - a category falling within certain defined limits and plans to invest in the fund for the long term. If John would be satisfied with either fund, he should choose the ABC Index Fund. Because it has a low portfolio turnover rate, much of the income he hopes to realize from the investment will be deferred until future years, when he redeems his shares. The fund's annual shareholder distributions should be less than those of the ABC Growth Fund, which actually enhances the Index Fund's return over the entire time John plans to hold it. However, one of the disadvantages of investing in mutual funds is that, unlike holding individual securities, shareholders do not have total control over when unrealized gains Unrealized Gain A profit that results from holding on to an asset rather than cashing it in and using the funds. Notes: Let's say you own a stock that has doubled, but you haven't sold it yet. This is said to be an unrealized gain. will be recognized for tax purposes. In this regard, index funds and tax-managed funds typically provide shareholders with more control than do actively managed funds, because they have a lower annual portfolio turnover rate. Index funds and tax-managed funds may also be a good alternative to annuities or other retirement-oriented investments. Editor's note Editor's Note (foaled in 1993 in Kentucky) is an American thoroughbred Stallion racehorse. He was sired by 1992 U.S. Champion 2 YO Colt Forty Niner, who in turn was a son of Champion sire Mr. Prospector and out of the mare, Beware Of The Cat. Trained by D. : This case study has been adapted from Tax Planning Tax planning Devising strategies throughout the year in order to minimize tax liability, for example, by choosing a tax filing status that is most beneficial to the taxpayer. for High Income Individuals Edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ((800) 323-8724; ppc.thomson.com). Editor: Albert B. Ellentuck, Esq. Of Counsel King & Nordlinger, L.L.P. Arlington, VA |
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