What Is a Tax-Efficient Fund? Benefits, Types, and Strategies for Investors

Commitment to Our Readers

GOBankingRates' editorial team is committed to bringing you unbiased reviews and information. We use data-driven methodologies to evaluate financial products and services - our reviews and ratings are not influenced by advertisers. You can read more about our editorial guidelines and our products and services review methodology.

20 Years
Helping You Live Richer

Reviewed
by Experts

Trusted by
Millions of Readers

Dealing with taxes as an investor can be complicated, but the last thing you want is to lose more money to the Internal Revenue Service (IRS) than you have to. That’s where tax-efficient funds come in.

Tax-efficient funds are mutual funds designed specifically to reduce your tax liability as a shareholder when you file for taxes. Because of the way they’re structured, you can keep more of your earnings, thus maximizing after-tax returns.

If you want to save money at tax time, it’s important to understand how tax-efficient funds work, the different options available and the potential drawbacks of structuring your portfolio this way.

How Tax-Efficient Funds Work

If the goal is to maximize your tax-after returns, a tax-efficient fund could be a crucial part of your investment strategy. Compared to some other assets, like dividend-paying stocks, tax-efficient funds have a lower overall tax liability.

The reason for this is simple. Tax-efficient funds are structured to maximize long-term capital growth, but on an after-tax basis. This leaves very little deferred tax, which lowers the future tax bill.

Tax-efficient funds reduce taxable distributions by:

• Purchasing investments that are already low-taxed or tax-free: This lowers the investor’s tax liability. Examples include municipal bonds, exchange traded funds (ETFs) and mutual funds.
• Reducing the fund’s turnover rate: Tax-efficient funds, especially those that invest in stocks, are structured to hold those assets for the long-term. Since they limit sales of existing holdings, these funds can lower the risk of short-term capital gains.
• Limiting short-term capital gains: Nearly every investment you own is considered a capital asset, including stocks and bonds. When you sell an asset (like a stock) and receive more than its adjusted basis (cost), you’ll be subject to capital gains tax. If you sell a stock within a year of purchase, the net gains will be taxed as ordinary income at graduated tax rates (10% to 37% for single taxpayers). If you hold it for over a year, you’ll typically be taxed at a lower rate.
• Managing income-generating assets: Dividend-paying stocks and other income-producing assets are taxable by the IRS. Tax-efficient funds can limit these income-generating assets to further lower your tax liability. Note that qualified dividends may be taxed at a lower capital gains rate.

Types of Tax-Efficient Funds

Creating the right investment strategy is all about choosing the assets that work best with your timeline, funds and risk tolerance. For many investors, this means including tax-efficient funds that can offset the taxable gains.

Here are some of the most common types of tax-efficient funds:

• Index funds: These are a type of exchange-traded fund or mutual fund that’s designed to track the performance and returns of a specific market index, like the S&P 500 or the Russell 2000. Unlike more active options, which aim to outperform the market, index funds usually try to maximize returns by holding securities for the long-term. Along with reducing short-term capital gains, index funds may have lower costs than more actively managed funds.
• Municipal bond funds: Municipal bonds, or municipal bonds, are debt securities issued by states, cities, counters or different government entities. They can fund day-to-day obligations or projects, like schools or highways. Investors who purchase and hold these bonds typically receive regular interest payments until the maturity date (at which point the principal will be returned). Municipal bonds may be exempt from federal, state and local income tax.
• Exchange-traded funds (ETFs): ETFs allow investors to invest in multiple securities (like stocks or bonds) simultaneously. The investor may then receive dividend payments from any dividend-paying assets in the ETF. Traditional ETFs tend to be highly tax-efficient due to fewer capital gains distributions, while non-traditional ETFs are less tax-efficient due to more frequent trading.
• Tax-efficient mutual funds: With a mutual fund, investors pool their money into different securities (like bonds, stocks and short-term debt) to create what’s known as a “portfolio.” Each investor can then purchase shares in mutual funds. An example of a tax-efficient fund is the T. Rowe Price’s Tax-Efficient Equity Fund, which aims to minimize taxable distributions while maximizing long-term capital appreciation.

Benefits of Investing in Tax-Efficient Funds

For investors, investing in tax-efficient funds has many advantages, including:

• Tax savings: Reducing your tax liability means keeping more of your returns. This can make it easier to achieve other financial goals since less of your money’s going to the IRS.
• Long-term growth potential: When you sell an appreciated asset, you realize those gains. By holding assets long-term, you can benefit from compounding growth and avoid short-term capital gains tax.
• Fewer taxable events: With tax-efficient funds, you can minimize the number of taxable events, thus reducing your tax bill.
• Portfolio diversification: Whether you choose index funds, municipal bonds or another tax-efficient fund, it can diversify your portfolio. This can mitigate risk, maximize returns and lower your tax liability.
• Wealth preservation: Tax-efficient funds may be beneficial for those seeking to preserve rather than build wealth. Take municipal bonds for example. These offer greater tax advantages, but offer lower yields (interest).

Strategies to Maximize Tax Efficiency In Your Portfolio

If you’re ready to make your investment portfolio more tax efficient, here are a few possible strategies:

• Hold funds in tax-advantaged accounts: Tax-advantaged accounts include traditional and Roth IRAs, traditional and Roth 401(k)s, ETFs, municipal bonds, index funds and tax-efficient mutual funds.
• Balance between taxable and non-taxable accounts: By investing in both types of accounts, you can lower your overall tax liability, reinvest your earnings and watch your money compound upon itself over time.
• Consider using tax-deferred accounts: Certain types of accounts, like traditional IRAs and 401(k) plans, are taxed on a deferred basis. What this means is you must pay taxes on distributions, but you’ll get an upfront tax break. Having tax-deferred accounts alongside your taxable and tax-exempt accounts can reduce your tax burden.
• Use tax-loss harvesting: This strategy can offset capital gains with capital losses, thus reducing your tax liability. Say you realize capital gains from selling an asset. You can then sell another asset for a loss to offset that gain. If your capital losses are higher than the gains, you can deduct up to $3,000 from the net loss from that year’s income taxes. If the loss was greater than $3,000, it gets carried over to the next year.
• Hold funds for more than a year: Keep your assets for at least a year before selling them to avoid short-term capital gains tax. Remember, long-term capital gains (realized after more than a year) are usually taxed at a lower rate.

Potential Drawbacks and Considerations

Tax-efficient funds come with a few limitations that might not exist with other types of investment accounts. These may include:

• Lower yields: Some tax-efficient funds provide lower annual returns. While this does mean a lighter tax burden, it can also be limiting for investors who rely on income from their investments.
• May still be taxable: While some options, like Health Savings Accounts (HSA), are tax-exempt (when used as intended), earnings from tax-efficient funds may still be subject to capital gains tax. This can lower your overall earnings.
• Passively managed: Actively managed funds may strive to outperform the market, while passively managed funds typically aim to match it. Many tax-efficient options, like ETFs and index funds, are passively managed.
• Contribution limitations: Certain tax-advantaged accounts, like IRAs, have annual contribution limits to be aware of. For IRAs, the current limit is $7,000 ($8,000 if you’re 50 or older).

As you consider your investment strategy, consider your options. Tax-efficient funds can be useful if you’re trying to reduce your tax liability and don’t mind potentially lower overall yields (good for those with a lower risk tolerance or those in the wealth preservation phase of life). But as with any other strategy, it may not be right for everyone. If you’re not sure about which strategy is best for you, speak with a financial advisor or tax professional.

Share This Article: