Taxes: Which Fund is Tax Friendly?

I just recently finished my portion of the household tax return for 2009. I was not that unpleasant a task as I broke even for the year. Some stocks made money while others lost enough to offset those gains. In other words, the best possible tax scenario took place: no gains, no tax consequence. But that was my mad money account, a little side game I play in the stock market based on advice given to everyone who read Benjamin Graham’s work: The Intelligent Investor.

Graham invented the term “mad money account” suggesting that after your financial house was in order, after your retirement was fully funded, it was quite alright to play the stock market, if only to teach you a lesson in how heartless investing can be. He believed that some folks had it while others would never possess the skill needed to make a sufficient amount of profits to be considered a successful investor.

Oddly, most of us disregard this advice believing that we can become investors, and good ones at that, with the information we have at hand. And some of us do. But the vast majority do not. Unless of course we use mutual funds.

While mutual funds have always been a somewhat difficult concept to understand, it is what we have to work with. And because the vast majority of us who come into contact with these funds do so inside a 401(k), an account where the taxes that might be paid by an investor outside are deferred to some point in the future, do taxes matter?

Yes and no. Yes because mutual funds can deliver tax consequences that eat away at your returns and no because if you pick the right fund, those tax events will have less of an impact on your return which means more retirement dollars.

How do mutual funds create tax events? Unfortunately, the same way you create them as an individual investor: buy selling profitable holdings. Mutual fund managers look for great stocks and when they find one, they hold on to it. So utterly confused tip one when looking for a good mutual fund is to find a manager who trades infrequently.

This is expressed as portfolio turnover. If a fund manager buys and sells everything she or he owns in a given year, the turnover is 100%. The lower the turnover, the lower the trading costs and the lower the chances are you will have to pay taxes. The higher the turnover the more likely there will be some taxes to be paid and a greater chance of lower overall returns.

But sometimes, as was experienced at the end of 2008 and into 2009, mutual fund investors, just like everyone else panicked and sold their shares in the fund as their portfolios fell in value. When this happened, the fund manager had to give them cash and the only way they were going to get the cash was to sell something. If it was a profitable holding, it created a tax event.

But who paid the taxes? Unfortunately, it was the shareholders who didn’t sell. And sometimes the new shareholders who unwittingly bought into the fund just as the taxes were distributed. In a mutual fund, every thing is, well, mutual: the gains, the losses and the taxes.

An older gentleman once suggested that taxes were one way to know you made money. But how do you avoid them? Second utterly confused tip: only buy after a scheduled distribution. They generally take place at the end of a quarter or the end of the year. Buy in after that, and the taxes you pay are on the shares you own.

The last utterly confused tip for mutual funds is finding a long-term manager. This is not as easy as it sounds especially if you are locked in a plan that has only a few funds or funds from the same family. Look for a fund with a good long-term consistent performance instead. This is one indication of stability in trading and as a result, less taxes to subtract from your return.

You may pay taxes on your gains when you retire and when you begin to take distributions, but the fund pays taxes on its activities all along and deducts them from your returns.