A fund’s short-term capital gains, long-term capital gains, and dividends are passed through to investors as though the investor earned the income directly. The investor will pay taxes at the appropriate rate depending upon the type of income as well as the investor’s own tax bracket.
The pass through of investment income has one important disadvantage for individual investors. If you manage your own portfolio, you decide when to realize capital gains and losses on any security; therefore, you can time those realizations to efficiently manage your tax liabilities. When you invest through a mutual fund, however, the timing of the sale of securities from the portfolio is out of your control, which reduces your ability to engage in tax management. Of course, if the mutual fund is held in a tax-deferred retirement account such as an IRA or 401(k) account, these tax management issues are irrelevant.
A fund with a high portfolio turnover rate can be particularly “tax inefficient.” Turnover is the ratio of the trading activity of a portfolio to the assets of the portfolio. It measures the fraction of the portfolio that is “replaced” each year. For example, a $100 million portfolio with $50 million in sales of some securities with purchases of other securities would have a turnover rate of 50%. High turnover means that capital gains or losses are being realized constantly, and therefore that the investor cannot time the realizations to manage his or her overall tax obligation.
In 2000, the SEC instituted new rules that require funds to disclose the tax impact of portfolio turnover. Funds must include in their prospectus after-tax returns for the past 1-, 5-, and 10-year periods. Marketing literature that includes performance data also must include aftertax results. The after-tax returns are computed accounting for the impact of the taxable distributions of income and capital gains passed through to the investor, assuming the investor is in the maximum tax bracket.
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