Tax-Efficient Mutual Funds and ETFs: How They Work and When To Use Them 

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Tax-efficient funds are mutual funds and exchange-traded funds (ETFs) designed specifically to minimize your tax liability. Paying less tax means you keep more of your investment earnings, thus maximizing after-tax returns.

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

What Is a Tax-Efficient Fund?

Tax-efficient funds are designed to reduce capital gains taxes by limiting taxable distributions. That means more returns stay invested and less tax is owed later.

How Tax-Efficient Funds Reduce Taxes

Tax-efficient funds reduce taxable distributions by:

• Use of low-taxed or tax-free investments: Examples include municipal bonds.
• Low portfolio turnover rate: Tax-efficient funds hold stocks and other assets for the long-term to avoid short-term capital gains, which are taxed at a higher rate than long-term capital gains.
• Limited taxable income distributions: Tax-efficient funds aim to reduce taxable dividends by limiting income-heavy investments or favoring qualified dividends, which are taxed at lower capital gains rates than ordinary income.

Why Tax-Efficient Funds Are Best for Taxable Accounts

Although you can invest in tax-efficient funds within your individual retirement account (IRA) or other tax-advantaged account, you won’t save much on taxes because of the benefits those accounts already provide.

A taxable investment account, on the other hand, has no inherent tax benefits, so you get the full tax-savings effect when you add tax-efficient funds to the portfolio.

Turnover, Distributions and Why They Matter for Taxes

A turnover ratio is the percentage of assets traded within the fund over the course of a year. It’s important because the fund generates a profit or a loss with each sale. The higher the turnover, the more short-term capital gains the fund is likely to generate. Short-term capital gains are taxed as ordinary income.

To understand why that matters for taxes, consider this:

• Long-term capital gains typically have a tax rate of 0% to 15%.
• Ordinary income, on the other hand, is taxed at 10% to 37%, depending on your tax bracket.
• A low turnover ratio minimizes the number of trades that result in shareholders paying that higher, ordinary income tax rate.

Types of Tax-Efficient Funds

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

• Index funds: These are a type of ETF 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. They usually try to maximize returns by holding securities for the long term.
• Municipal bond funds: Municipal bonds are debt securities issued by states, cities, counties or other government entities. They may be exempt from federal, state and local income tax.
• ETFs: These are similar to mutual funds but are more tax-efficient because their trades (turnover) are structured in a way that shields investors from short-term capital gains.
• Tax-managed mutual funds: Managers of these funds limit investors’ tax liability by minimizing their turnover ratios and holding securities for the long term. They also might sell off poorly performing assets at a loss to offset capital gains — a strategy called tax-loss harvesting.

Examples of Tax-Efficient Funds

Investors have dozens of tax-efficient mutual funds and ETFs to choose from. Here are two examples.

How Dividends and Capital Gains Show Up on Your Taxes

Funds make money the same way individual investors do: by trading shares at a profit, and by earning dividends and interest on their holdings. But whereas you keep your gains, dividends and interest, a fund pays them out to shareholders.

Funds distribute capital gains net of capital losses and fees, as well as dividends or interest net of fees, at least once per year. These distributions are taxable if you hold the fund in a taxable account.

• If a fund distributes capital gains on assets it held for a year or less, your capital gains distribution is taxed as ordinary income.
• If the fund held the asset for longer than a year, your distribution is taxed as a long-term capital gain.

Dividend payments you receive can be “qualified,” meaning they’re taxed as long-term capital gains, or unqualified, meaning they’re taxed as ordinary income.

The fund reports capital gains and dividends to you and to the Internal Revenue Service (IRS) using Form 1099-DIV. You use the information on the 1099-DIV to calculate and report your gains and losses on Schedule D (Form 1040) when you file your tax return.

Good To Know

Some tax-efficient funds use a strategy called tax-loss harvesting. If you have a net capital loss in any given tax year, you can employ the same strategy within your own portfolio.

The IRS lets you deduct up to $3,000 or the limit shown on Schedule D, whichever is less. If the loss exceeds that amount, you might be able to “carry forward” the loss to future years.

Benefits and Drawbacks of Tax-Efficient Funds

Investing in tax-efficient funds comes with advantages and limitations, including:

Key Takeaways

As you consider your investment strategy, consider your options.

• Tax-efficient funds can reduce your tax liability by minimizing after-tax capital gains.
• The funds aren’t tax-free or tax-deferred unless you hold them in a tax-advantaged retirement account.
• Index funds are typically more tax-efficient than actively managed funds, but they might not perform as well.

Angela Mae Watson contributed to the reporting for this article.

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